Understanding the ESG Consequences of Factor-Based Investing: Part 2



In our previous blog, we looked at the S&P Factor Indices’ ESG exposures, showing that factor exposures can have an influence on ESG scores. In this blog, we’ll discuss these scores at the sector level and see how implementing an ESG or carbon reduction strategy on poorer ESG-performing factor indices can help investors gain not only factor exposure but desirable ESG exposures.

What Drives These Low Scores? 

Sector allocations are important for determining carbon metrics. Exhibit 1 shows how the weighted average carbon intensities of the 11 GICS® sectors differ. As with the carbon intensity data distribution, this is heavily skewed. The Utilities sector performs particularly poorly, with average emissions well over double the next-highest-emitting sector. Energy and Materials sectors also showed to be high emitting.

Understanding this, we can infer that factors with large exposures to Utilities, Materials, and Energy sectors are likely to have high carbon footprints.

When it comes to ESG scores, there is a sector bias. This sector bias shows how sectors in the S&P 500 compare to their global peers, as the data is normalized at the industry level based on the S&P Global LargeMidCap and S&P Global 1200 constituents. A skew is apparent, although not as strong as for the carbon intensities data (see Exhibit 2).

These sector skews of carbon intensities and ESG scores can potentially affect the factor indices, alongside other drivers such as stock-specific ESG characteristics.

How Constant Are the Sector Allocations within Factor Indices over Time?

The consistency of sector allocations is factor dependent. Exhibits 3-5 shows weight fluctuations in the Utilities, Materials, and Energy sectors for the various factors. The S&P 500 Equal Weight Index shows little fluctuation over time, whereas the S&P 500 Low Volatility Index and S&P 500 Momentum fluctuate significantly.

Overall, a responsible investor may wish to invest in strategy based on a quality-focused index. Alternatively, this investor may wish to implement an ESG or carbon reduction strategy for poorer ESG-performing factor indices, to gain not only factor exposure, but also desirable ESG exposures.

Furthermore, it could be beneficial to continually revise this type of analysis, since these ESG exposures will fluctuate over time, especially with those factors whose weights fluctuate to a greater degree. Ultimately, understanding the ESG consequences of factor exposure may lead to a more holistic investment approach.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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