Combining smart beta strategies with a consideration of environmental, social and governance (ESG) requirements can generate higher risk-adjusted returns, according to AXA Investment Managers.
AXA IM conducted a back test of portfolio performance over almost five years and found a combined smart beta ESG strategy portfolio would have outperformed both the MSCI world index as well as a smart beta strategy on its own.
The ESG smart beta equity portfolio used for this study was formed by passing the AXA IM smart beta equity strategy through four filters, including earnings sustainability, volatility, speculation and distress.
The portfolio was then diversified to remove high concentration in large companies and weightings of the smart beta index were adjusted based on each stock’s ESG score.
AXA IM global head of responsible investment Matt Christensen said while there has been limited academic research on the compatibility of ESG and smart beta, AXA IM’s study indicates the combination of the two approaches can “offer investors a lower total risk and higher return than index investing, along with improved diversification and strong ESG performance”.
“They may seem unrelated, but both approaches reflect a move by investors away from the unintentional and often uncompensated risks associated with traditional index tracking,” said Mr Christensen.
Both approaches also demonstrate a “greater willingness by investors to make their own determinations about desired exposures, risks and expected returns”, he said.
AXA IM believes the overall improvement in risk and return may make an ESG smart beta investment strategy attractive to investors looking to capture both financial and ESG performance in the long term.
AXA IM's director for Australia and New Zealand, Craig Hurt, said overlaying the two strategies is a “relatively novel concept” and that the results will encourage the industry to consider smart beta and ESG in tandem.
“Now that we have addressed MSCI, our next area to investigate is to include emerging markets and test this approach in an All Country World Index (ACWI) sense,” said Mr Hurt.