Is there a cost to sustainability?

Measuring the factor exposures of ESG and low-carbon investing in equities

  • The rewards of being socially responsible
  • Blending an ESG and a factor approach
  • ESG integration goes beyond portfolio construction

While there is a growing consensus that applying a sustainable investment approach to an investment strategy, including environmental, social and governance (ESG) criteria and thoughtful stewardship, is desirable from an ethical, moral and fiduciary perspective, investors may also want to do so in the hopes of earning improved returns and avoiding negative outcomes.

So, it is legitimate to ask whether a sustainability-focused investment approach adds to alpha performance or detracts from it: introducing a constraint to any type of portfolio management typically limits either the opportunity set or renders management less than optimal.

We believe there are many reasons why rational investors should find it compelling to adopt a sustainable investment. For example, research has found that there is a positive relationship between ESG factors and the financial performance of companies and that the cost of capital was lower for companies with good sustainability standards.

We have already mentioned the fit between an investor’s fiduciary duty and an ESG approach. For certain types of investors, supervisors and regulators are recommending, and increasingly asking, that ESG factors be integrated into their fiduciary duty. An ESG approach is socially desirable since it better aligns investor interests with society’s broader objectives. When managing risk, an ESG approach involves a long-term view, which is also more fitting when assessing, say, profitability.

At BNP Paribas Asset Management, we endorse all these aspects of sustainable investing as we seek long-term sustainable investment returns, built on the firm foundation of quality assets, for our clients. While we have engaged in sustainable investment for some two decades now, research into this area is fairly new and through our Sustainability Centre, we are committed to expanding the body of knowledge and establishing a firm academic basis in this field.

Being socially responsible: does it have its rewards?

Studies of ‘sin stocks’, which typically score poorly on ESG criteria and accordingly rank low on sustainability, have highlighted their good market performance,[1] but also show that this performance comes from aspects other than ESG.[2] Put simply, ‘sin stocks’ outperform the wider market because they are shares in small, profitable businesses, much like shares in other small profitable businesses, not because of their ‘sin’ features…

In other areas too, an ESG approach can come at a cost to shareholders: child slavery is obviously evil, but it does provide companies with a very cheap workforce, as long as companies can get away with it. Similarly, not paying for pollution can be profitable, as long as it is permitted.

So, what is the impact on the investment performance of the ESG scoring methodology used by BNP Paribas Asset Management, including the risks and factor exposures?

To answer this question, the BNPP AM’s Quantitative Research Group studied 10 years of data covering the period since December 2009 for the large-cap universes of the US S&P500 and MSCI Europe indices. The study looked at the different levels of exclusion, inclusion or carbon reduction.

Firstly, we find that being overly selective can cause problems: keeping only 10% of the best ESG stocks adds more than three percentage points to the tracking error, reflecting the portfolio’s deviation from its chosen benchmark. Keeping half of the top ESG universe still generates more than 1.5 percentage points of tracking error. More interestingly, past ESG performance differs across regions: it had a positive effect on the US universe and a negative one on Europe. Therefore, irrespective of whether ESG adds alpha, it has not had a dominant influence over the past decade.

The relationship between an ESG and a factor approach

In terms of factor exposures compared to the factors used at BNPP AM, ESG is more coherent. Across the US and Europe, an ESG approach equates to being long the quality and low volatility factors and short small caps and value.

The quality and low volatility exposure resulting from an ESG-based selection is logical to us, given the typically strong link between good company governance and the quality factor: one would expect a well-managed company to be less risky and more profitable.

Explaining the resulting short small-cap exposure is harder, as it goes against the small-cap premium popularised by Fama & French.[3] It also suggests that larger companies are more conscious of ESG issues. The short exposure to the value factor comes mostly from taking into account pollution at an ESG level: for the same economic activity, a cheaper stock typically has a larger carbon footprint per dollar invested than a stock with a higher valuation multiple.

We found the sectoral biases of a ESG selection to be consistent across regions: long information technology and short energy. This would seem unsurprising when you compare an IT company’s carbon footprint with that of a utility or energy major.

It is worth noting that while US consumers pollute more than their European peers do, in terms of equity indices, the reverse applies: the energy-heavy MSCI Europe index has twice the carbon footprint of the US S&P, which is dominated by the FAANGs (Facebook, Amazon, Apple, Netflix and Google).

A practical example

Let’s now study a reasonable, core actively-managed strategy, with a 3.5% tracking error, evenly split across the four factors: Value, Quality, Low Volatility and Momentum.

By ‘reasonable’, we mean

  • excluding the decile of stocks with the worst ESG score (‘ex decile 10’ in table below)
  • selecting stocks that will increase the ESG score of the portfolio by 20% over that of the benchmark (‘int +20’ in table below)
  • stocks that will reduce the carbon footprint of the portfolio by 50% relative to that of the benchmark (‘carb + 50’ in table below).

These levels are compliant with most fund labels, including the French SRI Label.[4]

On such reasonable, actively-managed approaches, the style tilts of ESG are diluted, so that the final styles are maintained (see table below).

Table 1: Z-scores of US and European multi-factor equity portfolios with a ‘reasonable’ ESG approach

Table 1: Z-scores of US and European multi-factor equity portfolios with a ‘reasonable’ ESG approach

Source: FactSet, MSCI, S&P, exshare, Worldscope, IBES, Sustainalytics, BNP Paribas Asset Management; simulation period December 2009-February 2019. Based on total net monthly returns in EUR. Simulations gross of management fees and market impact, net of transaction costs. MFE: multi-factor equity. UNGCC: according to the UN Global Compact principles. Past performance is not indicative of future performance.

The results show that, overall, the effect on performance of an ESG tilt is negligible over 10 years. Over shorter periods of time, however, specific events can create small discrepancies in regional performance. As the graph below shows, the sensitivity to oil prices or the style tilt towards quality can create noise when it comes to the generation of alpha (excess performance).

Exhibit 1: Cumulated daily return in excess to multi-factor equity

Exhibit 1: Cumulated daily return in excess to multi-factor equity

Source: FactSet, MSCI, S&P, exshare, Worldscope, IBES, Sustainalytics, BNP Paribas Asset Management; simulation period December 2009-February 2019. Based on total net monthly returns in EUR. Simulations gross of management fees and market impact, net of transaction costs. MFE Carb-50: multi-factor equity with the reasonable ESG approach described above. Past performance is not indicative of future performance.

The need for ESG integration

Quantitative studies need to be humble with past data, especially for subjects that evolve rapidly. Our study covered the past decade, but it would be a mistake to assume that the next decade will be like the last one when it comes to ESG and climate change. On average, world temperatures have already risen by more than 1°C and the 1.5°C threshold will likely be reached within the next few decades. Even if we do not know when and exactly how such an event would translate in market prices, it seems naïve to us to believe that it will not happen in one form or another.

Besides, sustainability, or ESG integration, does not just concern portfolio construction. Our sustainable approach is built around our key investment beliefs[5] including meeting our fiduciary duty to investors and other stakeholders; stewardship; and responsible business conduct. These also play an important role, perhaps not directly in terms of generating alpha for portfolios, but certainly when it comes to helping to change the future of mankind.

We should rephrase our initial question: If an ESG approach has had little effect on past performance, do you as an investor want to be on the bad side of sustainability for the future? We invite clients and peers to join us and also become future makers, so that together we can assert our positive influence on the sustainability of long-term investment returns.

[1] Also see the Investopedia article on sin stocks on

[2] ‘Sin Stocks Revisited: Resolving the Sin Stock Anomaly’ published in the Journal of Portfolio Management, by David Blitz and Frank Fabozzi

[3] Also see the Investopedia article on the Fama and French three-factor model on

[4] Created and supported by the French Finance Ministry, the label aims to increase the visibility of SRI products among savers in France and Europe.

[5] Read our Global Sustainability Strategy document and find out about our commitment to integrating sustainable investment practices across all our strategies in the interest of our clients, and of the economy at large. Go to