Positive screen: ESG factors can be added to an index by emphasising green energy stocks © Getty
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A “niche of a niche” is one description of the combination of socially responsible investment with smart beta factors. The practice of marrying the two approaches is far from mainstream, but both strategies are growing in popularity, particularly among institutional investors.

The recent launch of indices and funds offering smart beta incorporating environmental, social and governance (ESG) considerations indicates there is investor appetite out there.

MSCI brought out its New Factor ESG Target Indexes in September, for example. These allow investors to integrate a responsible investment approach alongside smart beta factors that hunt good-value and low-volatility assets.

Candriam Investors Group introduced a range of specialised ETFs in June. In the US, providers Oppenheimer, NuShares and Columbia Threadneedle run socially responsible smart beta ETFs.

A survey by FTSE Russell shows nearly half (46 per cent) of global asset owners have an allocation to smart beta, and 41 per cent of those using it or considering its use anticipate applying ESG considerations.

The trend for big pension funds and similar investors to incorporate ESG screening in investment strategies is well established. “In the Nordics and Australia, in particular, it is the price of institutional admission [as an asset manager],” says Heidi Ridley, global chief executive of Rosenberg Equities, the quantitative arm of Axa Investment Managers.

Adding an ESG screen to smart beta strategies generally entails applying a filter for ESG factors before adding the traditional smart beta factor tilts such as momentum or value. Approaches on screening vary but are likely to both exclude stocks based on measures of controversy such as tobacco or arms, and to make a positive selection of stocks with good ESG ratings, such as green energy.

Rosenberg has been running a combined strategy for three years, and by the end of this year will have added ESG screening to all its strategies. The approach adds value and “fits well with our long-term philosophy, as even in our smart beta strategies, we are not looking for short term factors”, says Ms Ridley.

The investment manager evaluates companies on the basis of volatility, quality, tail risk and ESG.

Ossiam, an affiliate manager of Natixis Global Asset Management, is a quantitative investment specialist. In June, the provider merged its main minimum variance fund with an ESG filtered version. Bruno Monnier, portfolio manager at Ossiam, says there are further smart beta factors that offer synergies with ESG, and the group plans to switch at least half of its fund range to an ESG-filtered methodology.

The main challenge in running ESG-filtered smart beta strategies, according to Ms Ridley, lies in having a sufficiently broad universe of stocks to allow for screening.

State Street Global Advisors, which is preparing to launch a fund combining ESG screening and smart beta early next year, has identified similar difficulties. Stocks rated highly for ESG may not have the required smart beta characteristics — SSGA focuses on factors including value, low-volatility and momentum — and vice versa.

Highly rated ESG stocks do not score well for momentum and are typically larger cap. This makes it difficult to apply a rules-based approach, says Jennifer Bender, director of research for the global equity beta solutions team at SSGA. “Fortunately, modern portfolio construction techniques offer a way to solve the problem,” she adds.

Data issues are another hurdle. Companies are not typically required to disclose on ESG matters, as they are on financial ones. “We hired people to do research company-by-company,” says Ms Bender, but a lot of the information remains subjective. There is also significant variation across data providers.

The lack of standardisation is not necessarily viewed as a problem. “I don’t believe we should have general ESG ratings published on Bloomberg as a universal truth,” says Koen Van de Maele, global head of investment solutions at Candriam.

“It is better to have your own screening process and approach to ESG integration and not to over-simplify.”

Those yet to enter this niche market question whether there is sufficient demand. “The difficulty is ensuring that what we build meets the demand of enough investors to be worth building,” says Chris Mellor, head of equity and commodity product management, Emea, at Invesco’s PowerShares.

“There are almost as many approaches to ESG as there are investors”, he says.

ESG is not a factor in the same way as momentum or value. It is, rather, a risk-and-return characteristic, but it has yet to be established that it offers a reliable long-term premium, argues Ms Bender.

Still, for some investors, it is increasingly a starting point in their investment decisions.

Copyright The Financial Times Limited 2017. All rights reserved.