Analysis and News

Investing Strategies: Factor Investing and Empirical Evidence of ESG

BY ARMCORE VPI's Analyst: Govindra Raghubansi

Factor investing is an investment strategy that uses a systematic approach to invest in particular areas of the financial market across asset classes in an attempt to generate higher returns. Factor Investing combines aspects of two contemporary investment approaches: Active investing and Passive investing.

Active investing is a type of investing that aims to outperform the market by purchasing and selling equities to maximise earnings. This is also known as "trying to produce Alpha" on Wall Street. On the other hand, there is passive investing. Passive investing aims to capture market returns by adopting a buy-and-hold mentality. This portfolio strategy focuses on the long-term. On Wall Street, this is also referred to as Beta trading.

Hedge fund managers using a factor-based investing approach have been able to generate higher risk-adjusted returns while reducing long term risk. On Wall Street, factor investing is also referred to as smart strategic or alternative beta. Blackrock, the world’s largest asset manager, identifies two categories of factors: macroeconomic factors (economic growth, real rates, inflation, credit, emerging markets and liquidity) and style factors (value, style, size, momentum, volatility). Style factors explain risks and returns within each asset class, whereas macroeconomic factors explain risks across multiple asset classes. While many other factors under these two categories can be considered, ESG investing has been under the spotlight in recent years as a leading factor, with ESG assets under management surpassing $35 trillion at the end of 2020 (Bloomberg).

What does the empirical evidence of ESG investments on the growth of a business indicate? More than 2,200 academic studies have looked at the link between corporate financial performance (CFP) and environmental, social, and governance (ESG) activities. The earliest academic studies on the link between company financial performance and corporate social responsibility, a related concept to ESG, were published in the 1970s. Bragdon and Marlin (1972) attempted to prove a relationship between pollution and corporate financial success. A firm focused on addressing pollution concerns could not be successful at the same time, according to the dominant economic perspective put forward by economist Milton Freeman. Their study refuted this and found a positive relationship.

Research by Aberdeen Asset Management Group summarises the 2000 plus findings on ESG integration and shows 90 percent indicates a non-negative ESG-CFP relation, this means a positive or neutral result. A large majority revealed a positive relationship between ESG and corporate financial performance, with the authors concluding that ESG Investing is empirically very well founded.

The linkage between ESG and financial performance points to a growing consensus that good corporate management of ESG issues results in improved performance for investors.

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