AS interest in environmental, social and governance (ESG) picks up, Asian investors are now asking increasingly incisive questions of their asset managers on how to use ESG for their portfolio management strategies.

In a roadshow in Hong Kong last month, Mario Andreetto, chief executive officer of index provider Stoxx Ltd, was surprised at the number and quality of questions he has received on ESG.

“At all the meetings I have on this trip, there is always a question on ESG, and this is a new development. I have never experienced this before in Hong Kong,” Andreetto says in an interview with The Asset.

One question that was repeatedly asked, and fascinated Andreetto, was whether ESG is a factor or not in the context of smart beta investing.

This question is interesting on a number of levels. First, it indicates that investors are keenly interested in investing in ESG. Second, it also indicates that investors are looking at using ESG together with smart beta investing.

But responding properly to this question requires taking a step back and defining what is meant by a factor, and how it fits into smart beta investing.

Experts agree that a factor is an element that allows a fund manager to categorize assets, particularly equities, by their principal characteristics.

Examples include the value factor, which is used for categorizing value stocks; the low volatility factor for low volatility stocks; and the momentum factor for momentum stocks. Smart beta investing uses factors, such as value, low volatility or momentum for portfolio construction. (See “Defining smart beta”, The Asset, November 2017, pp. 34-35).

Well-established factors, such as value, low volatility and momentum, are supported by extensive data and research covering long periods and numerous market cycles.

“To be defined as a factor, it is required that it has to be well documented by very rigorous academic research. There should be economic rationale, or even financial theory, to support why this factor exists. For example, the factor must show that it bears some systematic identifiable risks so that by bearing the risks, investors are rewarded with the returns associated with it,” says Taie Wang, vice president and deputy head of research at State Street Global Advisors.

However, ESG can be loosely considered a factor when viewed only from the perspective of its attributes that relate to the environmental, social and governance.

“In this sense it can definitely be called a factor. It can also be incorporated in your investment strategy, just like you do with other factors, and incorporated into your investment decisions or portfolio construction. From this perspective it can be loosely called a factor,” Wang says.

On the other hand, Northern Trust is of the belief that ESG is a factor, but it is unique based on the fact that there is no simple definition for ESG as a corollary to how the industry might define a value factor by “price to book”, for example.

“That said a factor is a characteristic that explains risk and/or return. We, and others, have identified elements within the environmental, social and governance that have risk and return explanatory power. We see growing demand and quantitative application for inclusion of ESG as an extension of our factor-based investment platform,” says John McCareins, managing director and head of Asia-Pacific, Northern Trust Asset Management.

The experts agree that ESG can still be used for portfolio construction although its status as a traditional factor is not yet established.

For example, investors can use ESG scores that can be incorporated into their portfolio construction in conjunction with traditional factors.

“Based on our studies we have found that ESG is naturally aligned with key factors. For example, our studies found that companies with higher ESG scores tends to have lower valuation, tends to be of high quality, lower volatility, relatively large size. So, it’s aligned with the factors, therefore you can certainly build ESG into your factor portfolio,” Wang says.

 This article is an abridged version of “Is ESG a factor in smart beta investing?” published in the December 2017 print edition on The Asset magazine, and to be made available on The Asset Plus.