Robeco study: Why factor investing and sustainability go together perfectly
How can sustainable investments best be implemented? This is one of the questions that Robeco's experts have looked into in their latest study, "Sustainability Inside". While they identify some disadvantages of investing via passive vehicles, they conclude that factor investing is the best way to integrate sustainability into the investment process.
The view is increasingly gaining ground among investors that the consideration of sustainable aspects in financial investments has more advantages than disadvantages in terms of risk and return. Investors are increasingly using passive investments, i.e. exchange traded funds (ETFs) or smart beta approaches, to implement sustainable aspects in their financial investments, primarily for cost reasons. However, according to the Robeco study, these have a number of disadvantages with sustainable investments.
For example, they warn that a simple ESG score-based approach to passive products can lead to unwanted cluster risks. For example, European large caps tended to be more transparent than their counterparts from other regions. They therefore often have a higher ESG rating. In addition, there are the usual pitfalls of passive funds. For example, passive strategies are completely transparent and this offers arbitrage opportunities to opportunistic investors by anticipating certain trades. In addition, indices usually include those stocks that have already performed strongly. With index trackers, investors invest in overcrowded trades, which in turn drives up transaction costs.
In the meantime, however, there are also smart beta strategies that take sustainability into account and which, as surveys show, are also becoming increasingly popular. But even these would have some disadvantages, as the Robeco study shows. For example, they also suffer from the exploitation of arbitrage opportunities and from overcrowded stocks. Moreover, as with normal passive strategies, it is not possible to quantify the contribution of sustainability to performance. And smart beta strategies deal with the financial goals, i.e. return, and sustainability independently of each other rather than really integrating them.
This applies, for example, to strategies that rely solely on exclusion criteria. This is because these leave no room for improvement in individual companies that do not meet the criteria. And this in turn could lead to undesirable cluster risks in countries, sectors, a certain market capitalisation or even individual factors. One of the most important points here, however, is that passive strategies cannot be used to implement the individual wishes of investors with regard to sustainability.
The latter appears to be a key issue in sustainable investment. After all, there is no uniform definition of sustainability and everyone has different ideas of what is sustainable. For example, nuclear power may be sustainable for one investor because it does not produce CO2, but not for another because of the risks and the problem of final storage. Also, not every investor wants to weigh environmental, social and governance criteria in the same way. For some, environmental factors play a greater role, for others, social aspects. It is also important for more and more investors to take into account the sustainability principles of the United Nations.
Many investors, Robeco analysts also observe, would take a multidimensional approach to sustainability. For example, they would like to see the application of exclusion criteria combined with a best-in-class approach and a simultaneous reduction of the carbon footprint. According to the experts, quantitative approaches offer precisely this flexibility in the implementation of sustainability. For their rule-based nature makes it easy to integrate sustainable criteria into the investment process. Thus, in addition to a factor such as value or momentum, the ESG score can also be integrated without any problems. The ESG score is then just another factor.
Robeco's analysts have carried out empirical analysis for this. The passive approaches described above give rise to a conflict of interest between sustainability criteria and factors such as value, quality or momentum. This means that more sustainability in the portfolio comes at the expense of the allocation to the desired factors. Robeco's analysis shows that this is different with a quantitative approach, where sustainability is directly integrated into the investment process. The result is that only sustainable companies are filtered out that also have an attractive valuation, high quality and strong momentum. This is not necessarily the case with an approach that does not really integrate sustainability.
This means that in the case of incomplete integration, where portfolios are one-dimensional, they ignore either sustainability factors or factor allocation. This in turn leads to sub-optimal portfolios. Depending on preference, sustainability aspects or the factors would then play a greater role. When integrated into quant approaches, on the other hand, the results of the study show that it is possible in this way to improve the sustainability profile of a portfolio and at the same time achieve attractive risk-return characteristics.