Erik Christiansen

Investing in emerging markets (EM) equities offers diversification and adopting a multi-factor approach provides access to well-grounded return premia, while significantly reducing volatility, according to new figures from global index provider and research house Scientific Beta.

These additional return benefits are demonstrated in the long term, but also in more recent years. While the outperformance over standard cap-weighted benchmarks has been above 3% p.a. in the last two decades, it has been above 7% over the last one and three years.

“The attraction of investing in EM is multifaceted,” said Susan Rodgers, Scientific Beta’s Business Development Director for Australia and New Zealand.  “EM economies generally experience faster growth compared to developed markets (DM), which can potentially lead to higher returns on equities, albeit with higher volatility. Over the period since 2001, EM equities have outperformed developed markets on a cumulative basis. Furthermore, this asset class provides diversification benefits to investors, as its returns have shown low correlation with those of traditional asset classes.”

“Our multi-factor EM strategy has outperformed the broad cap-weighted benchmark with lower volatility over the short and long term,” said Erik Christiansen, Head of Investment Solutions for Scientific Beta, as displayed by the performance table below.

Included in the multi-factor strategy are six well-established equity factors: value, momentum, size, low volatility, profitability, and low investment. “These factors have been critically reviewed and judged robust by financial practitioners and academics and have consistently delivered reliable and well-documented systematic premia across various geographical and market settings,” he said. “In addition, these factors are independent from one another, offering a powerful toolkit for crafting an EM equity factor strategy that can deliver robust returns to investors.”

Scientific Beta’s four-step investment process involves constructing factor-specific portfolios, avoiding negative exposures to rewarded factors by enhancing factor intensity, promoting diversification, replicability and investability by the use of liquidity rules, and equally weighting factor-specific portfolios to benefit from their decorrelation.

As the table below shows, while trading costs remain higher in Emerging Markets than in Developed ones, the trading costs of a multi-factor strategy are an order of magnitude lower than the return benefits it brings.

“This approach enables us to build an EM multi-factor portfolio with strong and well-balanced exposures to all six rewarded factors, which delivers robust risk-adjusted performance over the long-term. In addition, an EM multi-factor investment strategy delivers a well-balanced portfolio, leveraging the benefits of decorrelation and the cyclicality of premia.”

“Importantly, our high factor intensity filter removes companies that score poorly on a multi-factor score. The result is to meaningfully raise the factor intensity, by avoiding the dilution effect of stocks that are winners on one factor but bring negative exposures to the others. This approach proves particularly valuable in a multi-factor portfolio, where investors seek exposure to all rewarded factors to improve returns compared to market-capitalisation-weighted indices,” he said.

Scientific Beta builds its indices within regional building blocks, with separate underlying portfolios for example for India and China. This enables accommodating investors who wish to finetune their geographic exposures, such as with an Emerging ex-China approach.

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A new study from global index provider and research house Scientific Beta, Green Dilution: How ESG Scores Conflict with Climate Investing^[1], provides clear evidence of the dangers for investors of mixing ESG and carbon scores in equity portfolio weighting schemes, as it can come at great carbon cost for green investors.

“The green dilution is very strong, regardless of which ESG factors and scores are targeted as objectives, with our research revealing an average dilution of 92% across our portfolios,” said Erik Christiansen, Head of Investment Solutions for Scientific Beta.

“In other words, adding combinations of ESG scores to carbon intensity as a weight determinant in developed equity portfolios dilutes 92% of the initial carbon reduction objective. Only 8% of the carbon reduction objective survived the inclusion of ESG scores in portfolio weighting schemes,” said Mr Christiansen.

The green dilution has a simple explanation: the correlation between ESG scores and carbon intensity is close to zero.

“The two objectives are, simply put, unrelated. By adding too many ESG factors, investors lose focus on the carbon reduction objective. So if you are seeking to reduce the carbon intensity of your portfolio, you need to prioritise the decarbonisation objective,” Mr Christiansen said.

The Scientific Beta research reveals that the lack of correlation between carbon intensity and ESG scores holds true even if companies’ carbon intensity — their carbon emissions per unit of revenue or market capitalisation — is compared to their environmental rating.

“ESG ratings have little to no relation to carbon intensity, even when considering only environmental factors underpinning ESG ratings,” said Mr Christiansen.

Scientific Beta’s analysis is extensive, having included 25 different ESG scores from three major global ESG rating providers.

“Even just using environmental scores, rather than a range of ESG factors, leads to a substantial deterioration in carbon performance. You get a worse outcome by mixing social or governance ratings with carbon intensity objectives, which typically results in creating portfolios that are less green than the comparable market capitalisation-weighted index.  In other words, including social and governance scores more than completely reversed the carbon reduction objective,” Mr Christiansen said.

This dilution can be avoided through a separation approach, whereby ESG scores are used only for screening whether companies are included in a portfolio, then using carbon metrics to determine the portfolio weights.

“This conclusion arises naturally from the fact that ESG ratings and carbon intensity metrics are unrelated to each other. Our findings are robust across different ESG ratings providers, different carbon metrics and emission scopes, and different portfolio weighting schemes.”———–

Notes:
[1] Green Dilution: How ESG Scores Conflict with Climate Investing

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