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February 18, 2014updated 04 Apr 2017 2:30pm

Possible to combine ESG and SmartBeta equity: AXA IM

Consideration of environmental, social and governance (ESG) requirements can be compatible with smart beta investing, and combining the two approaches may produce higher risk adjusted returns finds AXA Investment Managers' latest ESG Insight - A responsible investment approach to smart beta equity investing.

By Verdict Staff

Consideration of environmental, social and governance (ESG) requirements can be compatible with smart beta investing, and combining the two approaches may produce higher risk adjusted returns finds AXA Investment Managers’ latest ESG Insight – A responsible investment approach to smart beta equity investing.

Matt Christensen, head of Responsible Investment at AXA IM, said: "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."

AXA IM built an ESG SmartBeta Equity portfolio (the ESG portfolio) that when back tested returned 3.22% on an annualised basis over nearly five years, outperforming the MSCI World Index which returned 0.84% over the same period.

The ESG portfolio matched the performance of the standard AXA IM SmartBeta Equity portfolio (the vanilla portfolio) but with important gains in terms of ESG performance, outperforming it and the MSCI World in terms of overall portfolio ESG risk and individual ESG risk sub factors.

The ESG portfolio demonstrated higher annualised volatility (17.47%) than the vanilla portfolio (16.08%) but markedly less than the MSCI Index (19.56%)(2).

The most significant impact of the additional ESG filters, in terms of sector allocation relative to the vanilla SmartBeta portfolio, were decreases in Energy holdings and Consumers Staples. The former was driven by ESG concerns often involving controversies, while the latter are often associated with issues around customer relationships and supply chain management.

The ESG filter over-weights Financials, Healthcare and Information Technology. Country exposures across the three portfolios were largely similar.

Matt Christensen added: "Many investors are now required to incorporate ESG factors into their investment policies. 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."

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 weighting of the vanilla SmartBeta portfolio was then adjusted according to each stock’s ESG score, based on different ESG factors including: environmental risks; health and safety; restructuring; relationship with customers and suppliers; audit, control and financial disclosure; and controversies factor.

Companies with the worst overall ESG profiles were excluded from the portfolio, while top scoring firms were up-weighted. The ESG portfolio contained 399 stocks, compared to the vanilla portfolio’s 465 and the MSCI World Index with 1593 stocks.

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