Andrew’s Angle

ESG in Factors

Andrew Ang |May 26, 2020

The capacity of factor strategies appears large 

If you’re a factor investor, odds are you already hold a portfolio that is ESG (environmental, social and governance) friendly.1 There’s scope for more, by constructing factor portfolios in tandem with ESG and carbon intensity criteria. Investors can also embed ESG data into factor definitions themselves—like incorporating green patents in value or corporate culture in quality.

Factors and ESG (environmental, social, and governance) are a complementary duo that are fast becoming as synchronous as peanut butter and jelly. In this Angle, I’ll explore how these two seemingly different investment concepts can be combined in the pursuit of long-term investment goals with improved sustainability measures.

Factors are ESG friendly

Recent BlackRock research validates that a diversified factor portfolio can have better ESG characteristics and lower carbon emissions than the market.2 Quality and low volatility are two factors with significantly better ESG profiles than the market.3 Oftentimes, companies with more stable earnings and less volatile companies tend to be larger, mature companies with experienced management teams that tend to be more thoughtful about their ESG impact and actively seek to minimize risk stemming from ESG considerations. Smaller companies tend to have data limitations and sometimes do not provide much ESG data.

Due to the high ESG scores of quality and low volatility, an equally-weighted multi-factor portfolio constructed from a global equity universe of five factors (value, quality, momentum, low volatility, and size) exhibits lower carbon emission intensity and better ESG scores relative to the broader MSCI World Index. Chart 1 summarizes the ESG and carbon scores of the benchmark factors relative to the MSCI World Index over January 2015 to September 2019. Where the X axis and Y axis cross, represents the MSCI World benchmark. The ESG scores represent percentage improvements relative to the market on the x-axis, while percentage carbon emission reductions are plotted on the y-axis. Thus, those factors in the top right-hand quadrant represent factors that have improved ESG scores and lower carbon emissions than the market as represented by the MSCI World Index.

Chart 1: ESG Score and Carbon Emission Intensity of Benchmark Factor Portfolios

ESG Score and Carbon Emission Intensity of Benchmark Factor Portfolios

Calculations by BlackRock,. Data from Worldscope, IBES, MSCI ESG and Barra, period of returns shown: January 2015 – September 2019. Factors portfolios shown are hypothetical and do not represent actual investible strategies. Theoretical factor portfolios of five factor strategies—value, momentum, quality, size and low volatility—in the MSCI World equity universe. Fundamental data from Worldscope and IBES are used to generate the momentum, value, quality, and size factors. For low volatility as well as momentum, we use equity returns and volatilities sourced from the MSCI Barra Global Equity Model (GEM3). We optimize the portfolios with MSCI GEM3 as the risk model. Portfolios are rebalanced monthly. The portfolios are constrained in terms of region, industry, and country to ensure risk is taken along the factor exposure dimension. In addition, we incorporate hypothetical transaction costs, with a similar model to Ratcliffe, Miranda, and Ang (2017), and control for turnover. ESG scores are defined as the MSCI industry adjusted ESG scores and carbon emission scores are based on MSCI Scope 1 (direct company -specific) and Scope 2 (indirect greenhouse gas emissions data) carbon emissions data.

If we want to take this concept further, we can improve the ESG score, and reduce carbon emissions through more intentional portfolio construction. By incorporating a preference for companies which display both positive ESG characteristics (higher ESG ratings or lower overall carbon emissions), as well as favorable factor exposures, it’s possible to build factor portfolios that achieve better ESG profiles and lower carbon emissions without detracting from historical performance.

Is ESG a factor?

Investment factors—like value, momentum, quality, size, and minimum volatility—satisfy four criteria:

  • Each factor has a solid academic rationale for the existence of a return premium
  • There are decades of empirical evidence that support the premium
  • Their return patterns are value-added to market cap indexes and they exhibit low correlations with other factors
  • They can be implemented at scale

Some, but not all ESG characteristics fit these four criteria. So, ESG by itself is not an investment style factor that is broad and persistently rewarded. But those ESG data that do meet these criteria can be incorporated in signals alongside more traditional financial data to create portfolios that seek to capture the factor premiums but that are also more ESG friendly.

The frontier of factor research is to incorporate ESG data into the factor definitions themselves. Let’s look at two examples.

Intangible green value

Green patents not only represent important priorities for society, but highly profitable, albeit risky, opportunities

Green patents not only represent important priorities for society, but highly profitable, albeit risky, opportunities

Source: BlackRock FBSG Research, as at September 2019. For illustrative purposes only.

Green Value

Intangible assets are becoming increasingly important for companies but are not typically captured in financial statements in the same way as traditional physical assets. One way to measure intangible assets is with patents.

Green patents are patents filed under fields corresponding to UN Sustainable Development goals (patents themselves are a measure of intangible assets; it’s intellectual property that can be sold or licensed). If a company can deliver clean water or renewable energy, then these are goals not only for society, but they also represent attractive commercial opportunities. We can incorporate green intangible value (falling into “E” of ESG) alongside more traditional value measures (like earnings yields or cashflow-to-enterprise value) to construct an ESG-friendly portfolio capturing the value factor.

Corporate Culture

Culture matters, but metrics around corporate culture tend to be driven by qualitative aspects of management and the environment in a firm. We can quantify this through machine learning techniques. These machine learning algorithms compile dictionaries corresponding to the pillars of corporate culture—innovation, integrity, quality, respect and teamwork. Words related to integrity, for example, include “transparency” and “accountability.” With this dictionary, we can count the frequency of these words in conference call transcripts and build a quantitative “Corporate Culture” score. This non-financial measure of quality, which reflects good governance (“G”) and social aspects (“S”), can then be incorporated alongside more traditional quality measures, such as balance sheet and earnings income statement variables.

The potential for a perfect partnership!

Factors and ESG are joined at the hip in many ways. Multi-factor portfolios may already exhibit ESG-friendly qualities. For investors who would like to explicitly combine factors with improved ESG characteristics, our research has found that building portfolios that optimize for both factor exposures and ESG criteria can potentially benefit performance as well as sustainability. We can take the incorporation of ESG one step further, by combining ESG measures in the definitions of factors—like green patents in value and corporate culture in quality—to complement the traditional measures of factors.

If you’d like to hear more about ESG in factors, tune into to BlackRock’s latest BID podcast where I join podcast host Oscar Pulido to discuss the sustainability of factors in greater detail.

Andrew Ang
Andrew Ang
Head of Factor Investing Strategies
Andrew Ang, PhD, Managing Director, coordinates BlackRock’s efforts in factor investing. He leads BlackRock’s Factor-Based Strategies Group which manages macro and style ...
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