Recently, Brown Advisory’s Karina Funk spoke at the Investing for Impact event in Boston, produced jointly by the SRI Conference and BASIC (Boston-Area Sustainable Investing Consortium). This series of regional events seeks to educate and inspire investment professionals on various topics related to sustainable investment, and also to build momentum for the annual SRI Conference, one of the oldest and largest sustainable investment conferences in the U.S. (This year’s conference will be held in San Diego, November 1-3.)
Karina is Brown Advisory’s Head of Sustainable Investing and co-portfolio manager of the firm’s Large-Cap Sustainable Growth equity strategy. Along with Tom Kuh from MSCI and Conor Platt from Etho Capital, Karina spoke on a panel entitled “Smart Beta: Is ESG Smart Enough?” Investors are keenly interested in the promise of smart beta strategies, which seek to deliver an enhanced risk/return profile by building portfolios with exposures to various quantitative factors (such as size, momentum, yield and so on). The panel dove into the topic of ESG as a potential smart beta factor.
Separating Alpha and Beta
One of the key points that Karina made during the discussion is that ESG data can be used to create both beta and alpha in portfolios, and investors should have a clear sense of what they want before deciding on how to apply this information to their investment decisions. To state things simplistically, if an investor has conviction that they want to bet on a particular style or quantifiable theme (like growth versus value), factor-based portfolios are a great way to do this. If investors want performance that results from individual stock selection, independent from the market, they should seek alpha exposure.
Is ESG a Smart Beta Factor?
The search for an ESG beta factor is up against a material challenge: A factor needs to be objectively quantifiable to be universally applicable in portfolios. As an example, consider the non-ESG “quality” factor used within the MSCI-BARRA model. The term “quality” may be a subjective concept, but those who use the MSCI-BARRA model have settled on an objective, quantitative definition: “quality” is measured using return on equity, debt-to-equity and earnings variability data. Karina drew a contrast between that definition of quality, and the more subjective, qualitative information that she finds valuable when assessing a company’s management quality. All active managers believe that management quality is important, even if few of them would assign a score to it; similarly, ESG information may be material to an investment decision, but not quantifiable in a way that would be necessary to use it as a beta factor
Karina also pointed out that even in instances where the data is sufficient, ESG beta exposure may not be useful if investors are more interested in good business models than in factor exposures. A company’s factor sensitivity does not tell us if that company enjoys high barriers to entry, if its business model is getting stronger, or if it is truly a company you want to own for the long term. In fact, she suggested that a singular emphasis on the value of ESG as a beta factor does a disservice on the value that ESG data can play in fundamental research and in driving alpha. Successful companies need a strong understanding of the risks they face—political shocks, macroeconomic shocks, natural resource constraints, sensitivity of their operations to climate risk, and many other issues—to ensure their long-term survival, and they can also adopt sustainable thinking in their business strategies to find new ways to grow faster, drive customer loyalty, and deliver more long-term value to shareholders. But each company’s circumstances, and the strategies that company adopts in response to those circumstances, are relatively distinct; there is no universal beta factor that will help investors consistently find those winning business models.
Our firm’s approach to investing is more focused on alpha than on beta—we emphasize fundamental research to drive our selection of individual stocks or bonds for inclusion in our portfolios. As such, we can speak to the use of ESG information as a source of alpha, and we have found success over time by using an ESG lens as an additional way of understanding a company’s business model and evaluating its return prospects independently from the market. ESG data may very well be a viable foundation for smart beta strategies. The skill of managers such as fellow panelist Conor Platt of Etho Capital goes far beyond a simplistic application of quantitative metrics to construct thoughtful and successful factor-based portfolios. We are simply speaking from our experience in using both quantitative and qualitative ESG data in a different way.
Karina Funk and David Powell—the co-managers of the Large-Cap Sustainable Growth strategy—address this topic further in an upcoming article, “ESG and the Stock Picker’s Dilemma,” in the Journal of Environmental Investing. Please click here for more information about how we are leveraging sustainable investment principles across our firm.
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