Sustainability in a Smart Beta World

Authored by Karen Wendt Sustainable Finance

Investors are reviewing their asset allocations and mandates over the coming months as a consequence of market adaptation caused by the Red Swan called COVID-19.  We expect investors to embrace invention, in the form of climate and sustainability-tilted smart beta strategies, referred to as Smart Sustainability. In this vein we consider the EU Taxonomy and the EU Action Plan for Sustainable Growth another important accelerator and game changer, supporting this trend. The confluence of these factors is set to accelerate the already explosive growth of sustainable investing. The Bank for International Settlement in Basel is now thinking about how to deal with the Grean Swan and how to create – what they call regenerative capitalism. All this shows, the sustainability movement may have reached a leverage point.

Whereas many players in the market are still in passive investment strategies, Smart beta strategies offer investors a low-cost means of taking a view on factors they believe will generate outperformance over time. Rather than simply tracking an index based on market capitalization, smart beta strategies use a series of pre-determined rules to tilt investment towards stocks based on particular factors such as value, quality, volatility, momentum, or yield.

Institutional Investors geban to consider “value”-focused indexes using fundamental factors to influence the weight of securities in the index based on objective and consistent rules that are not influenced by market over-exuberance. This had the effect of reducing returns on the way up, but providing considerable downside protection when markets fell.

Over the 15 years or so since smart beta products first saw widespread market acceptance, their popularity has exploded. Assets in factor funds rose from $565bn to $1.2tn in the last five years, according to Morningstar data.Recently , more than half (58%) of asset owners reported allocating assets to smart beta strategies, and more than three quarters (77%) of European asset owners expressed interest in applying environmental, social and governance (ESG) factors. ESG  considerations made their way into smart beta.

increasingly accept that incorporating data on an issuer’s ESG performance into investment analysis can help to reduce risk and improve returns.

These two trends have come together. We are finding that over the last couple of years a growing number of institutional investors have taken the opportunity to integrate certain sustainability parameters—usually climate related but sometimes other ESG measures, too—when they have awarded new smart beta mandates. Over the last couple of years this has become a majority, the new normal, for new asset owner smart beta mandates.

The contours of the post-COVID global economy have yet to come into sharp focus. But what is clear is that investors are taking a hard look are how they expect to generate returns in the new normal; smart sustainability strategies are likely to be an increasingly popular method of their doing so.