Consideration of environmental, social and governance (ESG) requirements can be compatible with SmartBeta investing according to AXA Investment Managers (AXA IM). Indeed combining the two approaches may produce higher risk adjusted returns than the cap weighted Market Indexfinds AXA IM’s latest ESG Insight – A responsible investment approach to smart beta equity investing.

“Smart beta and responsible investment are both garnering greater attention from investors. They may seem unrelated, but both approaches reflect a move by investors away from the unintentional and often uncompensated risks associated with traditional index tracking and a greater willingness by investors to make their own determinations about desired exposures, risks and expected returns. There has been little academic research on their compatibility to date, but our study shows that ESG SmartBeta can offer investors a lower total risk and higher return than index investing, along with improved diversification and strong ESG performance” comments Matt Christensen, Global Head of Responsible Investment at AXA IM.

According to AXA IM’s research the ESG SmartBeta portfolio which was created for the purpose of the study would have outperformed a ‘vanilla’ SmartBeta portfolio and the MSCI World on both the overall performance and the ESG risk score.[1]

To build the ESG SmartBeta Equity portfolio, AXA IM took its AXA IM SmartBeta Equity strategy as an initial vanilla portfolio. This portfolio is formed by passing the global equity universe through four filters: earnings sustainability, volatility, speculation, and distress. This process reduces exposure to sources of uncompensated risk. The portfolio is then diversified to remove the problem of a high concentration in larger companies that can be present in traditional market capitalisation weighted indices, while avoiding the liquidity risk introduced by many alternative weighted schemes.  The weightings of the smart beta index are then adjusted based on each stock’s ESG score from almost a dozen data points.

“Many investors are now required to incorporate ESG factors into their investment policies” Matt Christensen adds. “It might sound complex managing multiple objectives, but in the real world investors do have many different motivations and needs. If you look at the philosophical foundations of smart beta and responsible investment, the ESG approach is a natural fit with the idea that investors should avoid uncompensated risks. This research shows that SmartBeta strategies can be suitable for ESG investors and can deliver returns over the long-term.”

Craig Hurt, AXA IM’s Director of Australia and New Zealand said: “Overlaying these two strategies is a relatively novel concept and we believe the results provide a positive step for the industry to consider smart beta and ESG in tandem. Now that we have addressed MSCI, our next area to investigate is to include emerging markets and test this approach in an All Country World Index (ACWI) sense,” Mr Hurt concluded.

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