aligning factor and esg exposures to target sustainable ... · this view is not a testimonial of...

Christopher C. McKnett

Head of ESG Investing Business

State Street Global Advisors

Aligning Factor and ESG Exposures

to Target Sustainable Returns

ESG is Big. And Growing.

Over a quarter of the world’s professionally

managed assets

$22.9Trillion

11%Annual compound growth rate

*Source: GSIA. 2016 Global Sustainable Investment Review.2

The Current State of ESG

This view is not a testimonial of satisfaction with our advisory services and should not be interpreted as a statement of experience or an endorsement by a client, but rather an opinionon ESG investing in general. Many of the survey respondents are not clients of SSGA.* About this study: In December 2016 and January 2017, Longitude Research, in association with State Street Global Advisors (SSGA), surveyed senior executives with asset allocation responsibilities at 475 institutions. They included private and public pension funds, endowments, foundations and official institutions. The survey was conducted by a combination of telephone interviews and online. The results were analyzed and collated by Longitude Research and supplemented by a series of in-depth interviews. This survey explored institutional Investors’ attitudes toward ESG adoption. It sought to gain insights into their strategic approach, asset allocations, performance measures and challenges.

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Portfolio Returns Are Driven by Factor Exposures and Pure

Alpha

STYLE FACTORS

Interest rates

Economic growth Inflation

Liquidity

Size

Term Quality

Value

Volatility

Liquidity

Momentum

Credit

Factor timingCountry selection

Sector selection

Security selection

4

Academics Have Been Studying Factors for

More than a Half Century

Sharpe (1964)

“Capital Asset Prices:

A Theory of Market Equilibrium

Under

Conditions of Risk”

Ross (1976)

“The Arbitrage Theory of

Capital Asset Pricing”

Banz (1981)

“The Relationship Between

Return and Market Value

of Common Stocks”

Fama & French (1992)

“The Cross-Section of

Expected Stock Returns”

Carhart (1997)

“On Persistence in Mutual

Fund Performance”

Elton, Gruber, Agrawal

& Mann (2001)

“Explaining the Rate

Spread on Corporate

Bonds”

Arnott, Hsu &

Moore (2005)

“Fundamental Indexation”

Gebhardt, Hividkjaer

& Swaminathan (2005)

“The Cross Section of

Expected Bond Returns: Betas

or Characteristics”

Popisil & Zhang (2010)

“Momentum and

Reversal Effects in

Corporate Bond Prices

and Credit Cycles”

Baker, Bradley &

Wurgler (2011)

“Benchmarks as Limits

to Arbitrage:

Understanding the

Low-Volatility Anomaly”

Carvalho, Dugnolle,

Lu & Moulin (2014)

“Low Risk Anomalies

in Global Fixed Income”

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We Believe These Factors Are the Most Persistent

in Driving Excess Returns Across Asset Classes

Past performance is not a guarantee of future results.

VALUE

Inexpensive stocks

tend to outperform

more expensive

stocks.

SIZE

Stocks of small

companies tend to

earn greater returns

than stocks of

larger companies.

VOLATILITY

Lower volatility

stocks tend to

generate a higher

risk-adjusted return

than high volatility

stocks.

QUALITY

Healthy companies

tend to outperform

less healthy

companies.

MOMENTUM

Stocks with good

recent performance

tend to continue

earning greater returns

in the near term

compared to stocks

with weak recent

performance.

EQUITIES

FIXED INCOME

YIELD SLOPE

Longer maturity

bonds tend to

earn higher

returns than

shorter maturity

bonds.

TERMCREDITLIQUIDITY

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Integrating ESG into a Multi-factor Portfolio

• MSCI uses ESG criteria to score securities on a scale of AAA-CCC.• AAA is the highest rating possible, relative to a company or issuer’s peer

group, while CCC is the lowest

Attribute Definition

Valuation Price/Fundamental

Fundamentals: Earnings, Cash Flow, Sales, Dividend, and Book Value

Volatility Volatility of Total Return

60-month variance

Size Market Capitalization

Free float market capitalization

Momentum Total Return

Trailing 12-month, excluding recent 1-month

Quality (1) Profitability, (2) Earnings Consistency, and (3) Low Leverage

ROA, EPS variability, LT Debt/Equity

Quantifying Factors

Quantifying ESG

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What are the Factor Characteristics of Different ESG

Categories?Highly Rated ESG Companies Are Cheap But Have Negative Momentum

Value and Momentum Exposure for Different Categories of ESG Rated Companies (MSCI World Universe, MSCI ESG Ratings, December 31, 2011 and December 31, 2016)

8

-0.2

-0.1

0

0.1

0.2

0.3

AAA AA A BBB BB B CCC

Exp

osu

re t

o V

alu

e

Average Value Exposure by ESG Rating as of 12/31/2016

-0.2

-0.1

0

0.1

0.2


Average Value Exposure by ESG Rating as of 12/31/2011

(the higher the cheaper)

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2


Average Momentum Exposure by ESG Rating as of 12/31/2016

-0.1

-0.05

0

0.05

0.1


Average Momentum Exposure by ESG Rating as of 12/31/2011


Categories?Highly Rated ESG Companies Are High Quality and Have Low Volatility

Quality and Volatility Exposure for Different Categories of ESG Rated Companies (MSCI World Universe, MSCI ESG Ratings, December 31, 2011 and December 31, 2016)9

-0.1

-0.05

0

0.05

0.1

0.15

0.2


Average Quality Exposure by ESG Rating as of 12/31/2011

-0.4

-0.2

0

0.2

0.4


Average Quality Exposure by ESG Rating as of 12/31/2016

-0.4

-0.2

0

0.2

0.4


Average Low Volatility Exposure by ESG Rating as of 12/31/2011

(the higher the lower volatility)

-0.4

-0.2

0

0.2

0.4


Average Low Volatility Exposure by ESG Rating as of 12/31/2016


Categories?Highly Rated ESG Companies Are Larger Cap (Negative Size)

Size Exposure for Different Categories of ESG Rated Companies (MSCI World Universe, MSCI ESG Ratings, December 31, 2011 and December 31, 2016)10

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2


Average Low Size Exposure by ESG Rating as of 12/31/2011

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1


Average Low Size Exposure by ESG Rating as of 12/31/2016


How to Integrate?

• ESG and factors won’t always be aligned

• Fortunately, modern portfolio construction toolkits offer an

effective way to resolve this problem

• We construct portfolios with exposure to: • High Momentum,

• High Quality,

• Low Volatility,

• Low Size, and

• High Value (cheap)

• Highly rated ESG stocks have historically been• Negative Momentum,

• High Quality,

• Low Volatility,

• Larger Cap, and

• High Value

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Momentum

Quality

Volatility

Size

Value

ESG

Challenge:

Include highly rated ESG companies into the portfolio while

delivering positive momentum and a small cap bias


*The predicted return is weighted average factor scores as the usual return input is replaced with factor scores in this exercise.

The universe is the MSCI World Index.12

With CCC

excluded

1509

2.83%

0.90

63%

158

0.74

0.50

0.89

0.50

0.50

With CCC

and B

excluded

1341

2.80%

0.90

59%

151

0.66

0.5

0.81

0.5

0.5

With CCC, B, BB,

and BBB

excluded

690

3.60%

0.90

50%

100

0.50

0.50

0.50

0.50

0.50

Whole

Universe

Number of names in starting

universe before optimization.

(Optimization process results

in fewer securities)

1560

Portfolio characteristics

Ex ante TE 2.84%

Ex ante beta 0.89

Predicted return* 65%

Number of securities 151

Exposures

Low Volatility 0.81

Momentum 0.52

Quality 0.92

Low Size 0.50

Value 0.52

Conclusion

The Next Frontier of ESG Investing

• ESG is not just limited to traditional passive and active constructs

• ESG can be incorporated in a range of investment approaches including smart beta and factor-

based investing

• Allows portfolios to be built that deliver the long-term premia possible by harnessing factors along

with favorable ESG characteristics

• The framework can be extended to magnify ESG characteristics to as little or as great a degree

desired by the investor. ESG can potentially be given equal or more importance as the core

factors.

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Important Disclosures

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Index Disclaimers

Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell

Indexes. Russell Indices are trademarks of Russell Investment Group.

Source: MSCI. The MSCI data is comprised of a custom index calculated by MSCI for, and as requested by, SSGA. The MSCI

data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial

products or indices. Neither MSCI nor any other third party involved in or related to compiling, computing or creating the MSCI

data (the “MSCI Parties’) makes any express or implied warranties or representations with respect to such data (or the results to

be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy,

completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in

no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other

damages (including lost profits) even if notified of the possibility of such damages.

The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make

no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability

for damages of any kind relating to the use of such data.

Standard & Poor’s, S&P and SPDR are registered trademarks of Standard & Poor’s Financial Services LLC (S&P); Dow Jones is

a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by

S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street

Corporation’s financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective

affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such

product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index.

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Important Risk Disclosures For Investment Professional Use Only. Not for Use with the Public.

Information represented in this piece does not constitute legal, tax, or investment advice. Investors should consult their legal, tax, and financial

advisors before making any financial decisions.

Equity securities are volatile and can decline significantly in response to broad market and economic conditions.

Investing involves risk including the risk of loss of principal.

Equity securities are volatile and can decline significantly in response to broad market and economic conditions.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an

index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart

Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that

factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing. While

diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address

cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.Concentrated investments in a

particular industry or sector may be more vulnerable to adverse changes in that industry or sector.

Gender Diversity Risk The returns on a portfolio of securities that excludes companies that are not gender diverse may trail the returns on a

portfolio of securities that includes companies that are not gender diverse.

Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less

volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as

much as companies with smaller market capitalizations.

All performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the

performance of any particular investment.

Web: www.ssga.com

© 2017 State Street Corporation — All Rights Reserved

Tracking Number: INST-7752

Expiration date: 5/31/2018

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