ESG and Factor Investing

ESG and Factor Investing

Thematic Indexing, Meet Smart Beta! Merging ESG into Factor Portfolios

  • Jennifer Bender, Xiaole Sun, and Taie Wang
  • Journal of Index Investing, 2017
  • A version of this paper can be found here
  • Want to read our summaries of academic finance papers? Check out our Academic Research Insight category.

What are the research questions?

A growing number of investors are seeking to construct portfolios that simultaneously capture the 1) long-term factor premia ( value, momentum, size etc.) and 2) have attractive ESG profiles.
The main research questions of the paper are as follows:
  1. Is the relationship between ESG and factor stable over time?
  2. How should blended ESG-factor portfolios be constructed? In particular, should ESG be incorporated as an additional factor or used to screen the universe?

What are the Academic Insights?

By studying the MSCI World universe, 5 risk premia ( value, momentum, size, quality and low volatility) and MSCI ESG ratings, the authors suggest the following:

  1. NO- the relationship between ESG and factor characteristics is likely to change over time and particularly for factors like value and momentum, which are cyclical.
  2. There are mainly two approaches:
    1. rules-based or heuristic portfolio construction
    2. optimization based portfolio construction, which is most effective when the objective is to maximize factor exposures while minimizing risk and controlling for other objectives

The authors suggest that, in case of ESG integration, solution b is preferable. With regards to the question on whether to screen the universe of treat ESG as an additional factor, the authors show that each approach has its pros and cons. The screening approach is the most straightforward and the one with the best performance because it is the one with the least constraints. Its cons are that it may not yield a positive ESG portfolio exposure. The optimization approach maximizes the exposures but if ESG metrics don’t have additional alpha, it will tend to detract from absolute risk-adjusted performance.

Why does it matter?

This article argues that the correct way to integrate ESG and factor exposures depends on the investor’s investment rationale and, in particular, his or her desired exposure, performance expectations, and preference for conceptual consistency.

The Most Important Chart from the Paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.


Many investors are starting to explore ways to integrate environmental, social and governance (ESG) considerations into their portfolios. Factor portfolios and indices which integrate ESG allow investors to capture both the long-term durable factor premia while allowing them to invest in companies with attractive ESG attributes. Traditional factors and ESG both have strong investment rationale for investors with long horizons. But how should blended ESG-factor portfolios be constructed? This paper discusses several ways in which to integrate ESG in factor portfolios. We show that the choice of which approach depends on the investor’s investment rationale behind integrating ESG, desired exposure, performance expectations, and preference for conceptual consistency.

  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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Elisabetta Basilico, PhD, CFA
Dr. Elisabetta Basilico is a seasoned investment professional with an expertise in "turning academic insights into investment strategies." Research is her life's work and by combing her scientific grounding in quantitative investment management with a pragmatic approach to business challenges, she’s helped several institutional investors achieve stable returns from their global wealth portfolios. Her expertise spans from asset allocation to active quantitative investment strategies. Holder of the Charter Financial Analyst since 2007 and a PhD from the University of St. Gallen in Switzerland, she has experience in teaching and research at various international universities and co-author of articles published in peer-reviewed journals. She and co-author Tommi Johnsen are currently writing a book on research-backed investment ideas. You can find additional information at Academic Insights on Investing.
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