Content area
Full Text
R ules-based non-market-cap-weighted index-based investing, also known as smart beta, advanced beta, factor investing, and risk premiums investing among its many names, has generated much discussion and research in recent times. Its foundations span decades, starting with Ross's [1976] arbitrage pricing theory. Smart beta or factor investing can generally be viewed as a way for investors to capture key sources of return (factors) through a transparent, cost efficient index. The most widely employed factors include the original Fama-French [1992, 1993] factors--value and (low) size--plus additional factors such as momentum, (low) volatility, quality, liquidity, and yield. These factors represent systematic sources of return and risk--risk premiums --or arise because of mispricing of securities by investors that fails to be arbitraged away because of limits to arbitrage or because of market frictions. Increasing familiarity with traditional academic factor models and new commercially available factor models has driven greater adoption of this factor-based approach.
In the same way that the study of the underlying drivers of risk and return has helped investors identify long-term, durable factor premiums, growing research into the potential impacts of environmental, social, and governance (ESG) issues on a company's financial performance is also helping investors understand how to integrate ESG risks and opportunities into their investment decision making. A growing number of investors are seeking to construct portfolios that allow them both to capture the long-term, durable premiums of recognized factor tilts and invest in companies with attractive ESG attributes. Some focus on excluding investments that are not in keeping with their missions or goals (e.g., screening out so-calledsin stocks , such as tobacco, alcohol, or gambling and potentially reducing total return). Other investors want to tilt their portfolios toward companies that exhibit positive ESG attributes to achieve market-like or better returns as well as a particular environmental or social impact.
But how should blended ESG-factor portfolios be constructed? That is the focus of this article. There are, in fact, several ways to do so, and as we will illustrate, the choice of method ultimately depends on the investment objective, assumptions about the relationship between traditional smart beta factors and ESG factors, and the importance the investor places on performance versus conceptual consistency. (We use the term "ESG factors" here loosely to...