Investors are marrying ESG with smart beta

Asset owners are being attracted to passive factor strategies where the underlying index is re-weighted by ESG criteria.

Four fifths of EMEA-based asset owners are planning to embrace sustainability considerations in their smart-beta investments, a new survey suggests.

In its fourth annual survey of sustainability considerations and factor-based investing, FTSE Russell found that, globally, the percentage of asset owners looking to apply ESG considerations to their smart beta strategies has grown from 40% in 2017, when the survey started, to 60% in 2020.

In addition, nearly half of those who anticipate applying ESG considerations to their smart beta strategies expect to increase allocation to ESG smart beta over the next couple of years.

“This trend is reflected in our engagement with clients where we work with a growing number of asset owners who wish to integrate sustainability parameters—especially climate risk—into smart beta indexes,” Jaakko Kooroshy, head of SI data & methodologies at FTSE Russell, said.

“We call this Smart Sustainability and apply a consistent factor methodology across both risk premia factors and sustainable investment parameters.”

FTSE Russell defines smart beta as an investment strategy that “applies an index-based investment strategy that is not traditionally market cap-weighted (i.e. fundamentally weighted, equal weighted, factor weighted, optimized, etc.)”.

Key focus

According to the survey, climate risk has become a particularly hot topic for smart beta investors, with 64% of respondents who intend to apply ESG/sustainability to their smart beta strategy planning to use a climate or carbon theme.

Broader environmental themes come a close second, with 59% of respondents planning to use this as part of their smart beta allocation, while 55% named governance and social themes such as human capital and human rights as their top concerns.

The FTSE Russell research identified that the latest smart beta sustainable investment strategies are continuing to become more sophisticated.

For example, re-weighting indices based on Sustainable Investment and ESG factors is becoming far more popular in 2020, while there has been a marked decline in interest for the more basic negative screening approach. Only 48% of respondents showed interest in the latter, down from 64% last year.

Outside of smart beta, the survey results indicate significant interest in ESG/sustainability considerations within fixed income and multi-asset strategies, with 58% and 31% of those already implementing ESG in their investments showing interest in these areas.

North America

Meanwhile, the survey found that North American investors are quickly catching up with their EMEA-based counterparts when it comes to ESG integration.

Kooroshy added: “In these turbulent times, this year’s survey results are a striking reminder that sustainable investment is becoming an ever more important consideration for asset owners, and that while regional differences persist, the gaps are narrowing with particularly rapid growth in North America.”

This year, some 42% of US-based asset owners indicated an interest in ESG within their smart beta strategies, up from just 17% last year.

Outside of smart beta strategies, some 63% of North American investors are implementing or considering sustainable investment adoption this year, up from 39% in 2019.

The vast majority (some 80%) of asset owners either evaluating or already implementing sustainability factors in their investment strategies are large players with AUM of $10bn or higher.