Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
No alpha in ESG: Scientific Beta
Scientific Beta senior investment specialist Mike Aked (pictured) has some bad news for those expecting outperformance just for being ‘good’. Reported links between high environmental, social and governance (ESG) scores and above-market returns have dissolved on the acid test of careful statistical analysis.
“The evidence is clear – and contrary to the belief of many investors – that there is no alpha in ESG,” Aked said.
Academic studies have shown that any ESG benchmark-beating powers promoted in recent years can be attributed to exposure to already well-known factors such as quality. In a 2021 paper titled ‘Honey, I shrunk the ESG alpha’, for example, Scientific Beta demolished claims that tilts to high-scoring ESG strategies either generated outperformance or provided downside protection.
“By relying on biased research results, which as such have no value, the promoters of alpha in ESG investing are taking the great risk of disappointing investors on this supposed outperformance and diverting them in time from an investment theme that is important for sustainable economic development,” Dr Noël Amenc, Scientific Beta CEO, said at the time.
Aked said the data suggests investors need to be more analytical about what they want from non-financial ESG exposures and how to express those intentions in a portfolio.
“But they are two distinct decisions,” he said. “If you tie them both together you lose focus.”
For instance, a new Scientific Beta paper published this month details how mixing ESG scores with carbon-intensity measures is counter-productive.
“We find that the carbon intensity reduction of green portfolios can be effectively cancelled out by adding ESG objectives,” the study says. “This green dilution occurs because ESG ratings have little to no relation to carbon intensity, even when considering only the environmental pillar of these ratings.”
For investors who want to incorporate both broader non-financial objectives and low-carbon measures in a portfolio, the paper recommends “first applying ESG exclusions and then weighting stocks to minimise carbon intensity”.
“Our finding that pursuing multiple ESG and climate objectives without the necessary precautions leads to green dilution is perhaps not surprising,” the Scientific Beta study says. “Financial innovation often comes up against unintended consequences. ESG investing is no exception to this phenomenon.”
Emerging out of European investment academic business EDHC in 2015, Scientific Beta specialises in offering factor-based portfolios and bespoke indices to institutional investors. Purchased by the Singapore Exchange in 2020, the group opened a base in Sydney last September, hiring Aked from fellow factor investor Research Affiliates and Susan Rogers from State Street Global Advisors to lead the charge in Australia and NZ.
This article originally appeared in Investment News NZ.
