Sustainable Factor Investing: ESG Considerations in your Factor Strategies
By Svetlana Borovkova and Ying Wu / June 2021
Investing in a sustainable way is currently the main investment trend. Sustainable investing appeals to the new generation of investors – millennials – and sustainability transparency and disclosure is increasingly enforced by regulators.
Factor investing, the modern investment workhorse, is another ongoing investment theme, with new factor-based investment products appearing almost daily. Many asset managers incorporate factor investing into their overall investment strategies. Multifactor investment strategies have shown their consistently superior performance over the past decade.
The goal of this paper is to combine these two investment trends: to show how sustainability considerations can be combined with multifactor investment strategies, and to demonstrate that adding sustainability considerations to these strategies does not diminish their performance.
Numerous papers have investigated the relationship between sustainability and corporate financial performance; most of them found that either sustainability has a negative impact on stock return (at least the short-term return), or the impact is insignificant (Borovkova & Wu, 2020).
In this research, we propose investment strategies based on factor model (Fama & French, 2016) and α-momentum (Hühn & Scholz, 2018), and incorporating sustainability (i.e., ESG) metrics. Instead of considering ESG as a separate investment factor, we propose to use sustainability as a screening overlay in multifactor strategies and as an aid in sector rotation. We show that our strategies incorporate sustainability at a low cost of financial performance, and that the resulting portfolios still significantly outperform the benchmark, just like traditional multifactor strategies do.
Specifically, we address the following questions in this research:
- Can sustainability be treated as an investment factor?
- What is the impact of sustainability, as a screening overlay and as the weighting criterion in sector rotation, on portfolio financial performance?
In what follows, we will go into more detail about our research; but firstly, we summarise our main findings:
- In both the S&P 500 and STOXX 600, sustainability cannot be considered as a traditional investment factor. Consequently, adding sustainability as a factor does not make a difference in portfolio performance – there is no significant negative difference
- Applying sustainability as an overlay and/or in sector rotation to multifactor strategies in the S&P 500 universe leads to a higher Sharpe Ratio compared to the unscreened factor strategies. Differently in STOXX 600 universe, it results in a slightly lower Sharpe Ratio. However, the tradeoff is acceptable, since the ESG-based screening scenario still results in at least 12.88% annualized return over the last decade
- Using the environmental (E) pillar score as the overlay or in sector rotation is a less attractive alternative than using ESG score as a whole, especially in STOXX 600 universe