ESG Funds Have Strong Factor Exposures

New research shows that funds that with an environmental, social and governance (ESG) mandate have factor exposures that differ significantly from the market, creating a challenge for investors who seek a specific factor loading for their overall allocations.

ESG considerations in investing have become mainstream. According to the Global Sustainable Investment Alliance, ESG investing now accounts for more than $12 trillion, one out of every four dollars under professional management in the U.S., and one out of every two dollars in Europe.1

Ananth Madhavan, Aleksander Sobczyk and Andrew Ang, authors of the study, “Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens,” published in the first quarter 2021 issue of the Financial Analysts Journal, examined how ESG attributes are linked to common equity factors. They began by noting, “if certain ESG scores are linked to positive, rewarded factor exposures, those ESG components are more likely to be associated with high excess returns. Investors might prefer managers whose ESG characteristics are associated with factors’ long-run risk-adjusted returns, which pro­vides transparency into the economic sensibility for positive performance.” A second benefit is that analyzing factor exposures allows an investor to more properly measure risk-adjusted performance. For example, the authors explained, “If ESG-friendly funds have low returns in excess of their benchmark, they still might be beating those benchmarks on a risk-adjusted basis. Measuring how factor exposures are related to ESG scores allows investors to make these risk-adjusted comparisons.”

Using a data sample that included 1,312 U.S. active equity mutual funds with $3.9 trillion in assets under management (93% of assets in the active fund industry), they investigated the relationship between a fund’s bottom-up, holdings-based (as well as a time-series regression-based approach) ESG score and its alpha and factor loadings. They used holdings from June 30, 2014, to June 30, 2019, at a quarterly frequency. Their ESG data are from MSCI. Active returns were defined as fund returns minus prospectus benchmark returns and were measured net of fees. For their factor analysis, they used seven long-only factor portfolios, proxied by the following MSCI indexes:

  • Value: MSCI USA Enhanced Value Index
  • Size: MSCI USA Risk Weighted Index
  • Quality: MSCI USA Sector Neutral Quality Index
  • Momentum: MSCI USA Momentum Index
  • Minimum volatility: MSCI USA Minimum Volatility Index
  • Large-cap multifactor: MSCI USA Diversified Multiple-Factor Index
  • Small-cap multifactor: MSCI USA Small Cap Diversified Multiple-Factor Index