In a nutshell
- Historically, value, momentum, quality and low risk factors have provided significant rewards
- The reward is largely unaffected by making an SDG integration or reducing your CO2 footprint
- In this way, factor investment and sustainable investment can be combined effectively
Factor investing means leveraging the scientifically proven premiums of factors such as value, momentum, quality and low risk. Adequate exposure to these factors is required to capture the long-term rewards associated with this investment style. As investors increasingly consider sustainability considerations, the key question is whether the integration of sustainability considerations will negatively impact a portfolio’s factor bias and result in poorer performance.
In the two previous “Index Insights” articles,1 we first analyzed the implications of integrating sustainability into a passive market capitalization approach, as well as the implications of an active investor’s investment opportunities. We were able to show that even after screening the investment universe using certain sustainability criteria, a passive investor can still benefit from risk / return characteristics similar to those of the overall market. Furthermore, it turned out that the distribution of equity characteristics does not change significantly for an active investor. In this article, we consider how the application of such sustainability filters affects expected factor premiums.
Factor premiums remain largely unchanged after SDG integration or reduction of CO2 footprint
As part of our analysis, we examined how an SDG integration or a reduction in the CO2 footprint would have previously affected the global premiums of the factors Value, Momentum, Quality and Low Risk. For this purpose, we simulated factor-based portfolios for different investment universes. Specifically, we created long / short portfolios for the value, momentum and quality factors and a long portfolio for the low-risk factor based on the market’s large and medium-sized segments.
We then built similar factor-based portfolios using an investment universe that either excludes companies that contribute negatively to the SDGs (according to Robeco’s SDG nomenclature) or companies that come from sub-sectors with the highest CO2 footprint. We then compared the performance of the factor-based portfolios based on the unlimited full universe with the portfolios based on the sustainable universes (which screen either SDG or CO₂).
Figure 1 shows that exclusion of equities with a negative SDG score or with a high CO2 footprint does not have a significant impact on the long-term performance of portfolios focusing on the factors value, momentum, quality and low risk. Factor premiums were consistently similar using the entire universe and sustainable universes.
Figure 1 | Factor premiums remain largely the same after SDG or CO₂ screening
Source: Robeco, FactSet. Global factor premiums in the period 1986-2021.
For example, the average premium for the value factor in the whole universe was 1.9% pa during the period considered, which corresponded to the value in the SDG-oriented universe. Here, too, there was an average annual value added of 1.9%. In contrast, the average value premium for the universe with a low CO2 footprint was slightly lower at 1.5% pa. In terms of momentum factor, the low-carbon universe exhibited a higher average premium than the entire universe. In the case of the SDG-oriented universe, on the other hand, it was somewhat lower. Interestingly, the average quality factor premium in both sustainable universes was higher than for the entire universe. For the low risk factor, the average premium was virtually identical for all three universes.
data and method
For our analysis, we used the monthly USD returns of the components of the FTSE World Developed Index (before January 2001) and the MSCI World Index for the period thereafter. The total period of our study was from January 1986 to December 2021. For each month, we constructed cap-weighted portfolios based on value, momentum, quality, and low-risk factors for three different universes: the entire universe (unlimited) and two sustainable universes (either with SDG or CO₂ screening to filter out stocks).
Robeco’s internal SDG system is used to allocate SDG scores to individual companies. This framework provides a transparent, consistent and repeatable approach to measuring a company’s contribution to the 17 SDGs. To determine historical approximations for these SDG scores, we assigned SDG scores to individual firms based on their subsector affiliation. Our method thus provided a subsector-based assessment of a company’s produced goods and / or services and their impact on the SDGs.
Subsectors that have a positive impact receive SDG scores ranging from +1 to +3 (slightly positive to very positive) depending on the strength and quality of their contribution. Positive contributions can, for example, be in relation to health, medicine and water. Similarly, sub-branches with negative impact receive SDG scores from -1 to -3 (slightly negative to very negative) depending on the extent of their negative impact.
Negative contributions can, for example, come from the areas of gambling, fast food and shale gas. As part of our analysis, we assumed that the SDG scores are unchanged over the entire observation period. For the SDG-oriented universe, we excluded all companies with negative SDG scores. This reduced the total market value by 20-25% and the number of available shares during the period considered.
Likewise, we first ranked all subsectors by their CO2 footprint based on their Scope 1 and Scope 2 emissions at the end of our observation period. Then, we excluded the companies that belong to sub-sectors with the highest CO2 footprint when they formed a low-carbon universe. We assumed that sub-sectors that have high CO₂ emissions today did the same in the past. The CO₂ screening resulted in a reduction of the total market value by about 20% and a reduction of the available inventories over time. In addition, the CO₂ footprint was reduced by more than 50% at the end of our observation period.2
Within these three universes, we built 5×5 factor portfolios ranked by market value and book / price ratio (Value), market value and performance over the last twelve-minus-one months (Momentum), market value and the ratio of gross profit to assets (Quality), and market value and Beta within the last 36 months (low risk). To account for the size effect, we used the average across the different quintiles sorted by uppercase. This resulted in five portfolios for each of the four factors, which were size neutral.
We constructed a long / short portfolio for the value factor, consisting of a long position in shares with a high book / price and a short position in shares with a low book / price; a long / short momentum factor portfolio consisting of a long position in the recent winners and a short position in the recent losers; a long / short portfolio for the quality factor, which includes a long position in shares with high profitability and a short position in shares with low profitability. Using these long / short portfolios, we estimated historical factor premiums by calculating average annual returns.
As for the premium on the low risk factor, we used a slightly different approach and only considered a long strategy in low beta stocks. We then determined Jensen alpha versus the cap-weighted return of all stocks within the unlimited full universe.
From our results, we deduce that the factor premiums that can be expected in the long term are largely unchanged after the integration of sustainability (using SDG or CO₂ filters). In general, we believe that single-factor or multi-factor strategies that integrate sustainability considerations (eg SDG integration and / or CO2 footprint reduction) are attractive to investors who outperform the wider market and exceed returns and who want to pursue a sustainable approach at the same time.
Jan Anton van Zanten, SDG strategist at Robeco
1 Sustainable Index Solutions Team, “Can Passive Investors Integrate Sustainability Without Sacrificing Returns or Diversification?” Article by Robeco, March 2022; and the Sustainable Index Solutions Team, “Does Sustainability Integrity Reduce Opportunities for Active Investors?” Article by Robeco, April 2022.
2 Measured using Scope 1 and Scope 2 issues determined by TruCost divided by the company’s value including liquidity (EVIC).
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