Traditional equity value indices, which incorporate only the least expensive companies, tend to be associated with a higher carbon footprint and a lower environmental, social and governance (ESG) score than corresponding traditional, market-capitalisation-weighted indices which invest in all listed companies. Can value portfolios be made sustainable?
We show that value portfolios do not need to overweight companies with higher carbon emissions. It is possible to tilt the allocation of value portfolios towards stocks with higher ESG scores.
In our view, the key to success is to reduce sector biases and to go for less risky, more profitable and relatively cheap companies.
Overall, we find that our sustainable US value multi-factor equity strategy has outperformed the non-sustainable US traditional value index in the last few years.
Value stocks trade at low prices relative to their fundamental values. Equity value indices such as the MSCI Value index typically include stocks in companies known to have a higher carbon intensity and lower ESG scores than those in the corresponding market-capitalisation benchmarks.
In exhibit 1, we compare the carbon intensity and ESG scores of the MSCI USA Value index with that of the broader S&P 500 index at the end of April 2022, using our in-house ESG scoring methodology. The carbon intensity was about 69% higher for the value index portfolio than for the S&P 500. As for ESG, the value index portfolio had a rating about 8% lower than that of the S&P 500.
For investors seeking sustainable investments then, the MSCI Value index would have no appeal. However, does value investing need to be like this? Can we construct a value portfolio with a lower carbon intensity and a higher ESG score than that of the corresponding market-capitalisation index that delivers at least the same performance and exhibits value style characteristics? We believe so.
Smaller sector biases cut CO2 intensity
The MSCI Value index ignores sector definitions in selecting the cheapest stocks. Because sectors such as information technology tend to trade at higher valuations than, for example, utilities, this index methodology tends to generate significant sector biases such as overweighting utilities. This results in a higher carbon intensity than the market cap index.
However, as shown in our recent article, reducing sector biases by diversifying sector exposures has a positive impact on risk-adjusted returns in the longer term. Sector-diversified value strategies with small or no sector biases have significantly outperformed more traditional value strategies that tend to tilt their exposures toward sectors with lower absolute valuations.
Reducing sector biases also reduces the carbon intensity of a value portfolio by no longer strongly overweighting high carbon intensity sectors such as utilities.
Tilting for quality and low volatility
Top ESG-ranked companies tend to be more profitable and less risky than others, as reported by providers of ESG company ratings (for example, MSCI). It is also a feature of our proprietary ESG scoring methodology, which relies on data from multiple providers.
Our sustainable US value multi-factor equity strategy is constructed to avoid strong sector biases by comparing valuations of stocks with those of sector peers when selecting the cheapest stocks. It also includes a small exposure to styles such as quality, low risk and momentum.
In that way, the strategy invests in the cheapest stocks from each sector that are also among the most profitable, with lower risk companies and strong momentum.
The strategy is made sustainable by imposing as an investment constraint a higher ESG score for our portfolio than that of the market-cap benchmark as well as enforcing a carbon intensity standard that is lower than that of the market-cap index. Satisfying such a constraint is made easier by sector diversification and a tilt towards the most profitable and least risky value stocks.
In exhibit 2, we show that the sustainable US value multi-factor strategy is clearly value tilted and that, as expected, valuations are much lower than those of the S&P 500 portfolio, and in line with valuations found in the MSCI USA Value portfolio.
Outperforming traditional value
The final question is how this sustainable strategy would have performed relative to a MSCI USA Value strategy.
In exhibit 3, we show the results. After almost four years since launch, the sustainable value strategy has outperformed. However, occasional headwinds should be expected, such as in 2022 when the sharp rise in oil prices led to outperformance of carbon-intensive energy stocks.
On average, a value strategy can be made sustainable by reducing sector biases relative to a market-cap index and focusing on more profitable and lower risk cheap stocks.
Despite occasional headwinds, we would expect such a strategy to outperform a non-sustainable value strategy in the medium to long term.
- Value investing: Is this the biggest opportunity since the tech bubble?
- Equity factor investing – Sunshine after the storm – Investors’ Corner (bnpparibas-am.com)
- Value investing: Is this the biggest opportunity since the tech bubble? – Investors’ Corner (bnpparibas-am.com)
- Value stocks – Different definitions can mean significantly different outcomes – Investors’ Corner (bnpparibas-am.com)
- “Value vs Glamour Stocks: The Return of Irrational Exuberance?” Journal of Investing, Vol. 31, Issue 2