Findings

The study suggests that factor tilts, rather than pure ESG considerations, drive factor returns. Environmental considerations emerge as particularly important in driving factor tilts, and we found that 75% of the variation in fund-level environmental scores can be explained by style factors. On the other hand, ESG components unrelated to factors carry insignificant excess return premiums that are economically small.

Recommendations

Investment managers can target ESG levels by taking on factor exposures or by concentrating on the idiosyncratic ESG components that are unrelated to style factors. However, to benchmark active management, it is essential to understand the relationship between factor exposures and ESG components. Given the study’s findings, recommendations for investment managers include:

• To factor exposure: Investors might prefer managers whose ESG characteristics are associated with factors’ long-run risk-adjusted returns, which provides transparency into the economic sensibility for positive performance.
• To focus on style factors: Managers may manage factor exposures to achieve ESG profiles either directly, by using factor funds or strategies that may be related to ESG scores, or indirectly through targeting factors.
• To understand investible factors: Active managers must be able to understand investible factors’ relationship with ESG metrics and understand which ESG metrics have a relationship with factor tilts.

ESG data

The ESG data in this paper is from MSCI, which constructs ESG data at the stock level, then aggregates it up to the fund level. MSCI ESG Ratings for funds are designed to measure the resiliency of portfolios to long-term ESG risks and opportunities. As well, the ESG metrics are applied to more than 600,000 equity and fixed-income securities globally based on more than 200 metrics in three categories: sustainable impact, values alignment, and risks.

Factor exposures and understanding factor tilts

Investment managers’ exposure to style factors and ESG outcomes depends primarily on the approach they take when targeting ESG levels. With specific regard to environmental ESG considerations, this study suggests that environmental factors significantly affect momentum, quality factor exposures, and small-cap multifactor groups. On the other hand, while funds with the highest ESG scores exhibit interesting patterns in relation to factors, funds’ idiosyncratic ESG components exhibit no relationship with returns.

Performance analysis

Using data on 1,312 active US equity mutual funds with $3.9 trillion in assets under management, this paper found that funds with significantly large ESG attributes – both as to aggregate ESG measures and to separate E, S, and G components – have factor exposures that differ from the market in important respects. Environmental factors initially emerge as significant in driving factor tilts, consistent with previous research.

Conclusion

Factor tilts drive factor returns for ESG exposures. Active managers may choose to manage factor exposures directly (using factor funds) or indirectly (through targeting ESG characteristics that are related to factors). However, whereas factor exposures can be significant drivers of ESG scores, idiosyncratic ESG components hold minimal excess return premiums that are economically small. The key takeaway for investors is that investment managers can target ESG levels by concentrating on style factor exposures or specific ESG metrics, with environmental metrics emerging as particularly important drivers of factor tilts.