Scientific Beta

The Autumn 2021 issue of the EDHEC Research Insights supplement to Investment & Pensions Europe questions the widespread practice of using ESG as an alpha signal, examines the issue of detecting greenwashing in climate investing and looks at how portfolio greenwashing compromises investors' climate engagement, introduces Scientific Beta's new inflation-friendly equity indices, discusses how to estimate stock-level exposures to macro-economic risks, highlights the pitfalls in constructing low carbon equity portfolios, presents Scientific Beta's series of Climate Impact Consistent (CIC) indices, and explores how to position equity portfolios for trade policy shifts.

The Autumn 2021 issue of the EDHEC Research Insights supplement to Investment & Pensions Europe is a Scientific Beta special edition.

Our first findings question a widespread practice of using ESG as an alpha signal. While many of the ESG strategies analysed have positive returns, adjusting these returns for risk shrinks ‘alpha’ (or excess risk-adjusted return) to zero. Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk.

We then identify greenwashing risks in the construction of portfolios that represent popular climate strategies, especially those that correspond to net zero alignment strategies. Across strategies focusing on climate, the climate scores only account for 12% of differences in weights across stocks. In contrast, market capitalisation accounts for 88% of the differences in weights in these strategies.

Greenwashing is also detrimental to the efficacy of engagement. While climate investing sets out to make an impact by pushing firms to take urgent action to address the climate emergency, there is a danger that investors end up paying for ‘feel good’ products that induce complacency. Likewise, engagement strategies that are not combined with consistent portfolio decisions could lead to a false sense of investor action, without leading to a real effect.

We look at Scientific Beta’s new series of inflation-friendly equity indices, which protect investors’ portfolios against rising inflation and deliver an equity market risk premium over the long term. These indices are ideal candidates to replace cap-weighted indices for investors with inflation fears and as equity components of a multi-asset portfolio that needs insulation against inflation shocks.

We propose a methodology to estimate stock-level exposures to macro-economic risks. The success of our methodology relies on the use of appropriate proxies for a relevant macroeconomic variable and robust measurement tools from statistics as well as textual analysis. Portfolios constructed with a target of high or low exposure to our forward-looking macro variables achieve significant exposures out of sample, which is not the case when using naïve estimation techniques or backward-looking economic variables, such as realised inflation or growth.

We present research results that suggest that using low carbon strategies as a source of alpha is costly to investors. This does not imply that investors cannot benefit from low carbon investing. Investors should analyse whether or not low carbon strategies can help them hedge climate risks or make a positive impact on corporate behaviour.

We introduce the Climate Impact Consistent (CIC) indices, which have a unique design that creates consistency between investors’ engagement activities and investment decisions to maximise the potential for real-world impact. Indeed, the real impact of investment decisions from a climate alignment perspective comes from the consistency between these decisions and the climate performance of the companies that make up the portfolio. This is what is achieved by the CIC indices, which weight each stock according to its intra-sector climate performance and alignment trajectory.

Following the rise in trade tensions across the globe in recent years, it has become more relevant than ever to have access to effective tools to manage exposure to the risk of shifts in trade policies. We have shown that it is possible to capture heterogeneity in exposure to trade policy risk among stocks to construct effective risk management tools. Our methodology allows us to consider several dimensions of exposure, which improves the robustness of the resulting trade policy sensitivity.