Given that Europe largely berthed the ESG movement and has pretty much mandated it across a significant portion of the investor base, it should come as little surprise that European stocks tend to rank the highest among major regions.
Although company coverage is improving, we suspect that large cap funds tend to score higher than small cap funds due to lower breadth of data coverage across the small company universe (that and larger companies are more likely able to shoulder the increased compliance and reporting requirements of monitoring and tracking ESG-relevant operating metrics).
Granted, most asset allocators incorporating ESG will adopt a relative approach rather than an absolute approach so as not to sacrifice diversification for the sake of pursuing ESG goals (or you end up with a concentrated U.S./European large cap program). However, this also risks the watering down of the ESG impact that many clients are starting to value as much as they value achieving their financial goals.
At the very least, advisors should disclose and explain these trade-offs with those clients seeking to incorporate ESG principles into their programs.
Integrating ESG With Smart Beta
Finally, we have some thoughts on integrating ESG with factor investing or smart beta. There has been some interesting research published by the likes of MSCI and AQR on improving factor scoring methodologies by removing the “junk” from the eligible universe before applying the scoring rules or factor optimization.
Applying “junk” screens to any rules-based approach—whether simple market-cap weighting or smart beta—to improve risk-adjusted performance could be an intriguing way of incorporating ESG principles while not sacrificing too much of the original mandate.
However, for the quant artist, it’s a fine line between “conditioning” a factor versus turning it into a Frankenstein amalgamation. There could be more interesting research into integrating ESG with traditional smart beta approaches.
As of the time of this writing, 3D currently holds KRMA in its client accounts. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
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