Roundtable 'Market Cap Weighted & Factor Investing': The trend towards sustainability

September 7, 2023

The trend towards sustainability and more impact seems to lead to more concentrated portfolios. What does this mean for passive and factor-driven portfolios? Is it possible to reduce the portfolio's climate risk without hurting returns?

These and other questions were discussed in the Roundtable 'Market Cap Weighted & Factor Investing', in which six experts, chaired by Erik Hulsegge, exchanged insights.

This is part 1 of the report.

By Hans Amesz

The trend towards sustainability and more impact seems to lead to more concentrated portfolios. What does this mean for passive and factor-driven portfolios? Can you still stick to market cap investing and is it still possible to capture factors efficiently if the number of names in a portfolio continues to be reduced?

Svetlana Borovkova: 'We take an in-depth look at strategies that use different types of ESG information to construct portfolios. It turns out that excluding names, for whatever reason, does not automatically lead to a better sustainability performance of the portfolio. I have serious doubts about even the fundamental premise of this kind of strategy.'

Antoine Lesné: 'The more efficient you want to be from an ESG point of view, the more concentrated your portfolio needs to be. The key question is how you do that to achieve your goals. It is very difficult to provide evidence of better ESG performance. Even if you had accurate data from an ESG point of view over the past ten years, the time frame is too short to say that you have performed better or worse. So you have to accept that there are deviations.'

Joop Huij: 'A direct consequence of implementing sustainability is a more concentrated portfolio. What does that mean for diversification and factor premiums? We investigated that and the results were quite surprising. In terms of the necessary diversification, there are far fewer names to invest in than we usually see. With about six hundred (instead of six or even ten thousand) names, you achieve the most you can with diversification. You can also significantly narrow the breadth of the investment universe without hurting the performance of a passive or factor strategy. I think the main dilemma is how to define 'sustainability'.'

Mark Voermans: 'Passive or factor investing is possible with fewer shares. I don't foresee a problem with a hundred or two hundred. You do need to pay close attention to portfolio construction and make sure your portfolio is well diversified. As more exclusions or other choices are made, the risk of unintentional exposures increases. That is doable with a few hundred shares.'

Marc Vijver: 'If you add sustainability factors to a universe, you are effectively already implementing factors that you might find attractive – momentum, size and so on. If you look for other factors, you will be in a more difficult position to implement them. As for market cap investing, I think that should be possible.'

If you add sustainability factors to a universe, you are effectively already implementing factors that you might find attractive.

Is there a correct definition of sustainability?

Huij: 'The sustainability ratings of the various rating agencies differ greatly from each other. How then can you compare which measure better indicates what is good and bad? We checked the sustainability score of the companies on the exclusion lists of large institutional investors. The results were quite shocking. About 20% to 25% of the excluded companies received an AAA rating from the major agencies, while we naturally expected a very low rating.'

Borovkova: 'According to various rating agencies, British Tobacco was at one point the company with just about the best ESG rating in the FTSE 100, even though it is on the exclusion list of many investors. Why? Because the company practices highly sustainable farming, has fantastic community outreach, and hires all diversities and women. So it scores extremely high on all parameters from different data suppliers, but no questions were asked about the products anywhere.'

Lesné: 'There is no agreement on how sustainability should be defined. Even regulators – think of the SFDR chaos – are grappling with which common definition would be acceptable from a political standpoint. We have to start with the regulators to try and understand what we want to do.'

Voermans: 'We prefer to implement a client's sustainability objective in portfolios. This concerns sustainability themes that the customer has chosen himself. Based on a conversation with a client, we look for ESG data points that best fit those specific themes and create exposure in the portfolio to those themes. But indeed, I would not recommend using a generic ESG rating if you are pursuing sustainability.'

It is probably much easier to reduce climate risk in a fixed income portfolio than in an equity portfolio.

Martijn Rozemuller: 'When we launched the first sustainable ETF more than ten years ago, there was still a serious debate about its definition. I had expected that debate to be over by now, but that is still not the case. Even the regulator is not able to offer a clear perspective on how we as a sector should deal with this. For me it is ultimately a kind of 'best effort'. As an industry, we should at least do our best to come to something that is justifiable, but ultimately it is the companies that in some cases clearly need to change their behavior.'

Lesné: 'We use data from various data providers, combine it with our own research and then come up with our own sustainability score.'

What does the pursuit of sustainability mean for returns?

Rozemuller: 'When we launched our first sustainable ETF, we had a similar fund, but without sustainability screening. We were able to compare the two over an eight-year period, and performance-wise they weren't really that different. One year the sustainable ETF did slightly better, the next year the other ETF. Both had about 250 components, with roughly sixty to seventy different names. The fact that performance did not differ significantly even over an eight-year period was surprising to me.'

Borovkova: 'First, I think the financial performance is different for an exclusion strategy than for a best-in-class equity strategy. These strategies differ significantly in terms of returns. The second point is that if sustainability is your mandate, you may be willing to sacrifice 1%, 2% or whatever percentage per year in returns for a more sustainable portfolio. But in many cases the mandate is solely aimed at the highest possible return, for example for the pension. I think that investors and companies should be very careful in this area and that the ongoing litigation in the United States is a warning in that regard.'

Rozemuller: 'Our first responsibility as an industry is to deliver performance. I think from a regulatory perspective we are being forced into too much of a template, which is not necessarily conducive to delivering returns.'

You can actually go quite far in reducing climate risk without negatively influencing the expected return.

Is it possible to reduce the portfolio's climate risk without hurting returns?

Huij: 'I think it depends on the extent to which you want to reduce the climate risk. It would be good if we agreed on a standard. The standard that is often used for this is the Paris-aligned benchmark. We did research and it showed that it is possible to achieve exactly the same return with a passive or value strategy, while maintaining the requirements necessary for the label 'Paris-aligned'. So the answer is 'yes'. You can actually go quite far in reducing climate risk without negatively influencing the expected return.'

Lesné: 'It is probably much easier to reduce climate risk in a fixed income portfolio than in an equity portfolio.'

Rozemuller: 'You can probably assume that with a good ESG screening you end up with companies that have better risk management. Without having clear scientific evidence for this, I assume that the risk-return ratio can be improved by ESG screening.'

Borovkova: 'My point is not about the climate, but about the social aspects of ESG. Many sociological studies have shown that diverse teams and companies perform better in the long run. That is one of the social aspects of the ESG story. There is potential if you are able to identify the kind of companies that will do better in the long run.'

Part 2 of the Round Table 'Market Cap Weighted & Factor Investing' will be published on Monday 11 September, part 3 on Thursday 14 September.