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You’ve heard of smart beta and, separately, of sustainability as it relates to responsible investment (RI). But what about smart sustainability?

The label is becoming more common as investors, both institutional and retail, increasingly focus on RI solutions as well as smart beta or multi-factor strategies.

Read: Most investors want disclosure of pay by gender: poll

“We’re seeing growth in demand for both smart beta and ESG [environmental, social and governance], and for smart beta and ESG together,” said Tony Campos, head of ESG, Americas at FTSE Russell, during an interview with Advisor.ca last week.

There’s still some confusion around investment strategies that consider either smart beta or ESG factors, or both, he concedes. But FTSE’s Russell’s latest smart beta survey—which looks at North American and European institutional asset owners—indicated “there’s clear demand from asset owners, who are interested in or already applying smart beta, to apply ESG [analysis] to that.”

Asset owners managing more than $10 billion are more likely to do this, he adds, and the survey also shows European respondents are ahead of North Americans in adopting joint smart beta-ESG strategies.

Read: What does smart beta really mean?

Campos, who spoke with Advisor.ca before his presentation on ESG and smart beta at the 2018 RIA Conference in Toronto on June 5, said it makes sense to marry the concepts because “they’re both about applying a rules-based, easier-to-understand [alternative] to what has traditionally been active management.”

In the smart beta space, constructing indexes involves looking at a set of “factor exposures and the risk premia associated with those, and delivering on them through a rules-based index,” says Campos.

“And ESG is the same way: if you want [exposure to] sustainability or climate leaders, there are ways to do that now in a passive investment vehicle using data that has been collected.” For example, you can construct an index based on how companies have scored on ESG factors, Campos explains.

Read: Why ESG analysis is critical: fund manager

Today’s sustainable indexes are becoming about more than who’s in or who’s out based on which names are divested or which names don’t meet minimum ESG scoring criteria, for example, he says. The smart beta element is “the weights that are applied to each security in the portfolio.”

He doesn’t see ESG analysis as equivalent to weighing “traditional risk premia factors like quality, value, size and growth.” However, Campos says “you can apply ESG characteristics in the same manner” to better align your investment, performance and sustainable outcomes.

Read: The ins and outs of green bonds

ESG growth challenges

One barrier to growth for ESG-related products and strategies is today’s ESG ratings and data tend to favour large companies versus small- to mid-cap names, said Amr Addas, adjunct professor at Concordia University and sustainable investing expert who presented during the same 2018 RIA Conference session as Campos.

This is because it’s easier for large companies to invest in and report on sustainable initiatives, Addas said, thus making is easier for them to “say good things about themselves.” For this reason, some investors may be skeptical of ESG analysis and data.

Read: Responsible investment here to stay, despite hurdles

Nonetheless, around $17.7 billion is invested globally across 140 ESG-focused ETFs, according to ETFGI data shared during the session. The majority is in funds that incorporate ESG factors across broad markets, but there are also themed funds that look specifically at clean energy, climate change, water or gender diversity, for example.

As interest in these products and strategies grows, it will also be key to continue dispelling myths about RI fund underperformance, Addas noted.

The good news? This is becoming easier, said Campos, since ESG products now have a long enough historical record to be comparable to regular funds.

Pointing once again to FTSE Russell’s smart beta survey, Campos said nearly half (44%) of institutional asset owners surveyed are considering ESG for performance reasons, up 13% from 2017. In prior years, asset owners were looking to ESG primarily for the good of society versus seeing it as a way to manage risk.

However, much of the growth in the RI space is “client- and institution-specific,” Campos says, meaning widespread adoption by managers and investors hasn’t yet occurred. Still, the inclusion of ESG factors in both regular and smart beta strategies is not only increasing but also “moving toward a more sophisticated and measurable method.”

Read: Unsure how to use ESG analysis? Start with G, says RI expert

Next steps for advisors, retail market

For the retail and wealth market, it’s key to “think about different approaches, techniques and preferences” when serving clients, Campos says.

While institutions have been considering different investment themes within the ESG lens for years, the retail market is now starting to do this and will need guidance.

Investors “want a clear indication of whether their portfolios align with their values, and that might mean we’re starting to reintroduce some tools that, in the institutional space, are not as much in favour anymore [such as negative screening],” Campos says.

Read: 4 drivers of growth in responsible investment

Where ESG analysis is paired with smart beta strategies, the hurdle will be finding ways to discuss how both work, says Campos. For example, a client may wonder why they still invest in oil if they’re not clear on the difference between 100% divestment versus lowering exposure through alternative weighting.

In that scenario, “the advisor’s challenge is describing the nuance around overweighting and underweighting as a result of the smart beta methodology,” when it’s coupled with ESG analysis, he says. The key is “you’re moving away from an exclusionary ESG approach to one that’s more inclusionary, which therefore gives managers more options in terms of investment outcomes.”

The benefit, Campos says, “is you can seek to track the broad market universe, but minimize the bets you might take on given industries and regions because of ESG scoring being applied in a more nuanced way rather than a strict in-or-out, selective way.”

Read: Sustainable ways to offer responsible investing

Nonetheless, what clients want will matter, and you may find the values and needs of different segments diverge. “Will high-net-worth be different than true retail? And, will there be different regional preferences that crop up.”

The answers aren’t yet clear, so advisors will have to do their research, monitor trends and encourage clients to be open about their values and investment goals.

Also read:

Why and how to address clients’ ESG values

Hazards of responsible investing in emerging markets

More responsible investment options for wealthy clients

Katie Keir is Content Editor of Advisor's Edge. Email her at Katie.Keir@tc.tc.
Originally published on Advisor.ca
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