Scientific Beta

An initial article in this Scientific Beta special issue employs exchange-traded funds to evaluate ESG investing, revealing the absence of superior returns compared to standard index funds in the past decade. It also scrutinises the inconsistency of ESG scores across providers, their limited predictive ability for future financial risks, and quantifies the trade-offs for "green" equity investors. Furthermore, it discusses conflicts between climate indices meeting PAB requirements and NZAOA and IIGCC guidelines. Subsequent articles introduce firm-level measures of exposures to macroeconomic risks enabling the creation of portfolios with reliable out-of-sample exposures, propose a multi-dimensional measure of risk exposure at the firm-level using data on industry trade intensity, corporate risk disclosures and stock returns, examine the recent outperformance of major US stocks, explore a four-step investment process for factor portfolios in emerging markets, and highlight that rewarded factors remain crucial in driving the risk and return dispersion of equity portfolios.

The Winter 2024 issue of the EDHEC Research Insights supplement to Investment & Pensions Europe is a Scientific Beta special edition.

In our first article, we use exchange-traded funds to assess ESG investing. This approach reliably reflects the real-world performance of the average ESG investor who uses passive strategies. We find that sustainable investing did not yield higher returns than standard index funds over the past decade.

We also examine the question of ESG scores. It is well known that ESG scores diverge widely across providers, putting their reliability into question. This divergence reduces any positive real-world impact that investment strategies built on such scores might have, as investors fail to focus their efforts on a common direction. ESG scores also seem to have little predictive power regarding future financial risks.

We then quantify the trade-off faced by a ‘green’ equity investor who has a priority of reducing carbon intensity while also improving ESG scores. We show that weighting global stocks by both carbon intensity and ESG scores completely cancels out the large carbon intensity reduction achievable for investors who solely focus on that objective. Investors can avoid green dilution by focusing portfolio construction on carbon intensity reduction while using ESG exclusions.

Over the last year, two of the main climate-oriented investor coalitions have published recommendations regarding net-zero benchmarks that call into question some of the technical requirements of EU-regulated Paris Aligned Benchmarks (PAB). In the following article, we show how climate indices that meet the PAB requirements can be in contradiction with some of the NZAOA and IIGCC guidelines, especially with respect to the funding of low carbon energy production.

We then introduce firm-level measures of exposures to macroeconomic risks that allow portfolios with reliable out-of-sample exposures to be created. Our methodology can be used to construct equity portfolios for investors who want to target macro risk exposures and for those who wish to reduce exposure to unrewarded macro risks.

In the following article, we propose a multi-dimensional measure of risk exposure at the firm level, using information on the intensity of trade in its industry, corporate risk disclosures and stock returns. The exposure measure captures heterogeneity in stock price reactions to US-China tariff announcements out of sample and goes beyond simple sector tilts. These features make our measure a useful tool for managing trade policy risk in existing portfolios or creating dedicated portfolios targeting this risk exposure.

We look at the recent outperformance of the US’s 5% largest capitalisation stocks, which was largely driven by the ‘Magnificent 7’ stocks. Historically, companies composing the US largest caps in periods of extreme outperformance then underperformed in subsequent years. We find that well-diversified portfolios underperformed in periods of increasing concentration of the US 500 cap-weight but, over the long term, they delivered lower risk and higher Sharpe ratios than concentrated portfolios.

Emerging market equities have traditionally offered diversification and the promise of substantial returns but have underperformed recently. While investing passively in emerging markets has led to poor outcomes, factor portfolios have done well both absolutely and relative to their benchmark. Our article delves into a four-step investment process that has not only navigated these turbulent times but outperformed the broader emerging market.

We finally show that rewarded factors are still a key driver of the risk and return dispersion of equity portfolios. From a cross-section perspective, rewarded factors play a central role, explaining on average about 60% of the dispersion of returns of portfolios that target explicit factor exposures.