Scientific Beta Newsletter

Issue 26 – ESG Special Edition, July/August 2019 | www.scientificbeta.com

Scientific Beta, Risk Awards Indexing Firm of the Year 2019

Offices in Boston, London, Paris, Nice, Singapore and Tokyo

Climate Emergency and Investor Responsibility

Responding to the threat of Climate Change is the most pressing and important challenge of our era. The Earth has warmed by about 1 degree Celsius (1.8 degrees Fahrenheit) from pre-industrial times and the resulting changes in weather patterns, sea levels and frequency of extreme weather events are already affecting ecosystems, human communities and economies on a global scale.

Global warming is driven by the accumulation in the atmosphere of greenhouse gases. Over three quarters of this accumulation has occurred after the Second World War as greenhouse gas emissions dramatically accelerated, due to rapid growth in the consumption of fossil fuels for electricity, heat, and transportation.

On the current course, emissions are set to double and temperatures to rise from 3.7°C to 4.8°C (6.7°F to 8.6°F) by the end of the century. This would cause severe, extensive and in some cases irreversible damage to natural and human systems, contribute to substantial species extinction, create large risks to food security, exacerbate health issues, and compromise outdoor work and agriculture in some areas. Global warming on such a scale would also increase the risk of triggering natural feedback effects, such as the thawing of large areas of greenhouse-gas holding permafrost, which could limit humanity's potential for adaptation (IPCC, 2014).

The Paris Agreement on Climate Change, reached at the twenty-first Conference of the Parties held in late 2015, is a universal and legally binding agreement whereby 195 nations agree to work jointly to limit global temperature rise this century below 2 degrees Celsius and pursue efforts to target 1.5 degrees Celsius of warming. For the IPCC, the 2 degree scenario could be delivered if emissions fell by 40-70% relative to 2010 by 2050 and to zero or below in 2100 (IPCC, 2014). Such drastic reductions suppose radical changes in infrastructure and industrial processes, notably "decarbonisation" of the energy supply sector, which needs to see emissions decline from the next decade and fall by 90% or more between 2040 and 2070.¹ These reductions are unlikely to take place without political leadership.

Unfortunately, signatories of the Paris Agreement have collectively submitted emissions reductions pledges that are short of the levels required to achieve the agreement's objective and the policies implemented by a majority of signatories have not been sized adequately to deliver these pledges; the stated intention of the United States to withdraw from the Agreement is also a major cause of concern.

Due to the timidity of the political response to date, businesses have mostly been able to continue to operate as usual.

However, it is conservative to assume that there will be growing ecological, socio-political, and economic pressure on governments to set and enforce climate policies to mitigate the consequences of Climate Change.

While political leadership has been sorely lacking in the past quarter century, 2019 could be a watershed year in the fight against climate change and its consequences. The Paris Agreement requires countries to submit new pledges in 2020 and ahead of this deadline, the United Nations Secretary General has invited leaders of government, business, finance, and civil society to convene in New York in September to commit to actions to address climate change. In particular, governments are expected to submit realistic plans to reduce emissions by 45% over the next decade and to zero by 2050. This meeting will convene at a time when public pressure has been mounting for governments to finally act in a decisive manner.

Following the example of Swedish teenage activist Greta Thunberg, millions of children have joined school climate strikes in over 125 countries this year to demand that governments implement a decarbonisation pathway aligned with the ambitions of the Paris Agreement. Youth strikes and civil disobedience actions in the United Kingdom have awakened public anger against the slow response to the challenge of global warming and have led the UK Parliament to declare a climate emergency on 1 May 2019 and then to sign into law upped decarbonisation targets at the end of June 2019. There is a renewed sense of urgency in tackling climate change and unprecedented momentum; with climate crisis disasters now happening at the rate of one a week, according to the United Nations Secretary General's special representative on disaster risk reduction,² public pressure is unlikely to abate soon.

The eventual policy response is likely to include prohibitions or caps for activities with high absolute emissions and high intensity of emissions and the repricing of carbon for all as the result of massive fossil fuel subsidies being phased out and carbon trading schemes or taxes being aligned with decarbonisation objectives. For most companies, this policy response is a major component of the risks of a transition to a low-carbon economy which also include the impacts from changes in technologies, social norms and consumer behaviour and those "Transition Risks" are more of a concern in the short and medium term than the hazards from Climate Change and their consequences, i.e. the well-documented "Physical Risks" from Climate Change.

In this context, while ethical and socially responsible investors should be expected to orient their investments, engagement and outreach policies to contribute to the fight against Climate Change, it is the duty of all fiduciaries to consider the possible financial impacts of Climate Change on their portfolios.

Scientific Beta is committed to assisting institutional investors contribute to the transition to a low carbon economy and improve the resilience of their portfolios to climate change risks. Its experience in the matter dates back to the design of a dedicated Low Carbon index offering that it unveiled on the occasion of the Paris climate conference and has included helping large institutional investors incorporate ambitious climate change objectives into smart beta and factor investing investment mandates and designing a series of low carbon and fossil fuel reserves free indices to support the launch by Desjardins of a new suite of responsible investing ETFs. The July 2019 introduction of a Low Carbon Fiduciary Option is a new milestone as it allows for seamless incorporation of Climate Change considerations across Scientific Beta's entire flagship multi-smart factor index offering.

Scientific Beta's flagship High Factor Intensity Multi-Beta Multi-Strategy (HFI MBMS) 6 Factor indices solidly outperform the capitalisation-weighted indices of their parent universes over the long-term but have indirect contributions to greenhouse gas emissions ("carbon footprints") and exposure to carbon-intensive companies that compare negatively to those of these benchmarks, primarily as a result of factor tilting. Thus, decarbonisation of multi-smart-factor indices is both especially relevant and especially challenging.

The Low Carbon fiduciary option combines three approaches to decarbonisation:

Negative screening ensures divestment from companies with significant coal involvement - the focus on Coal is mandated by it being the largest source of electricity and the conventional fuel with the lowest heating value normalised by greenhouse gas emissions.

Positive screening targets the companies with the highest emissions per unit of revenues (Carbon Intensity) in key sectors exposed to Transition Risks and beyond. Screening is region neutral but given flexibility to strike a balance between exclusion efficiency and sector protection, while upholding best-in-class selection within each affected sector. As representation of the various industry groups is preserved, so are their presence in the derived indices and the ability to build sector-controlled indices.

As acknowledgment that the best long-term investment strategies can be derailed by short-term performance considerations, the Low Carbon fiduciary option embarks a conditional adjustment mechanism that reduces the shortfall between the quarterly level of the Weighted Average Carbon Intensity (WACI) of the index and a desired long-term reference level, defined in relation to the level of the WACI of the parent-universe benchmark. WACI is targeted because it is the carbon metric that the Task-force on Climate-related Financial Disclosures recommends asset owners and managers report as a first step (TCFD, 2017).

The exclusionary screens of the Low Carbon fiduciary option incentivise the transition of shunned and other companies towards more sustainable activities and technologies and materially reduce the exposure of derived indices to assets that could be at a particularly high risk of stranding due to their coal involvement or that are likely to have high exposure to Transition Risks owing to their high Carbon Intensities. As such, derived indices demonstrate clear support to the transition to a low carbon economy and show higher resilience to Climate Change. These screens also promote reduced footprints in derived indices.

As the Low Carbon fiduciary option includes a Core ESG filter that also screens out companies that fall short of global standards of responsible business conduct and corporate governance or that are involved in activities that conflict with global ESG norms or their objectives, the pursuit of decarbonisation and financial performance is not allowed to inflict harm upon ESG norms.

The above expected benefits are confirmed in back-tests: Low Carbon versions of the High Factor Intensity Multi-Beta Multi-Strategy 6 Factor indices deliver drastic reduction of exposures to coal assets and the most carbon-intensive companies, material improvements in carbon footprints and a Weighted Average Carbon Intensity that, over the last ten years, is about half that of the benchmark on Developed Markets and even lower for Emerging Markets. These ESG benefits are delivered while retaining the financial outperformance of the standard flagship indices.

As such, the Low Carbon fiduciary option is relevant not only to ethical and socially responsible investors that wish to dissociate from companies that contravene global norms and promote the transition to a low carbon economy, but also to business-as-usual investors that recognise that Transition Risks may materially impact portfolio values and wish to mitigate these risks as a precaution.

References:

Intergovernmental Panel on Climate Change (IPCC), 2014. Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, R.K. Pachauri and L.A. Meyer (eds.)]. IPCC, Geneva, Switzerland, 151 pp.
Task Force on Climate-related Financial Disclosures (TCFD), 2017. Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, Financial Stability Board, available at https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-TCFD-Annex-062817.pdf.

Footnotes:

¹Carbon dioxide is the number one contributor to the greenhouse effect amongst the gases directly released by human activity and the key greenhouse gas to target for long-term global warming mitigation.
²One climate crisis disaster happening every week, UN warns, Guardian, 7 July 2019.

Scientific Beta Low Carbon Option – Supporting the Transition to a Low Carbon Economy and Protecting Multifactor Indices against Transition Risks

Over the last four years, Scientific Beta has accompanied investors in the transition to a Low Carbon economy with its off-the-shelf Low Carbon index offering and with indices designed to support custom mandates and responsible investing funds. To go further and put Climate Change considerations at the very core of its offering, Scientific Beta has now introduced a Low Carbon Fiduciary Option that can be applied across its entire flagship index offering, including where desired in combination with the Sector Neutral and Market Beta Adjustment Risk Control Fiduciary Options.

Scientific Beta's flagship High Factor Intensity Multi-Beta Multi-Strategy (HFI MBMS) 6 Factor indices solidly outperform the capitalisation-weighted indices of their parent universes over the long-term but have indirect carbon footprints and exposure to carbon-intensive companies that compare negatively to those of these benchmarks, primarily as a result of factor tilting. Thus, decarbonisation of multi-smart-factor indices is both especially relevant and especially challenging.

Low Carbon versions of the HFI MBMS 6 Factor indices deliver drastic reduction of exposures to coal assets and the most carbon-intensive companies, material improvements in carbon footprints and a Weighted Average Carbon Intensity that, over the last ten years, is about half that of the benchmark on Developed Markets and even lower for Emerging Markets. These ESG benefits are delivered while retaining the financial outperformance of the standard flagship indices.

The Low Carbon fiduciary option combines three approaches to decarbonisation:

Negative screening ensures divestment from coal companies, companies with coal reserves, companies with significant revenues from thermal coal mining, and Utilities that rely significantly on coal for power generation – the focus on Coal is mandated by it being the largest source of electricity and the conventional fuel with the lowest heating value normalised by greenhouse gas emissions; phasing out coal is a priority in transition scenarios. Negative screening is also performed in respect of companies that fall short of global standards of responsible business conduct and corporate governance or that are involved in activities that conflict with global ESG norms or their objectives. The latter ensures that the pursuit of decarbonisation and financial performance will not be at the detriment of ESG norms.
Positive screening targets the companies with the highest emissions per unit of revenues (Carbon Intensity) in key sectors exposed to Transition Risks and beyond. The exclusion budget is 10% of the regional universe by number of stocks. Screening is region neutral but given flexibility to strike a balance between exclusion efficiency and sector protection, while capping exclusions in each sector to 50% and upholding best-in-class selection within each affected sector. As representation of the various industry groups is preserved by this flexible best-in-class approach, so are their presence in the derived indices and the ability to build sector-controlled indices.

As acknowledgment that the best long-term investment strategies can be derailed by short-term performance considerations, the option embarks a conditional adjustment mechanism that reduces the shortfall between the quarterly level of the Weighted Average Carbon Intensity (WACI) of the index and a desired long-term reference level, defined in relation to the level of the WACI of the parent-universe benchmark. Based on minute sector weight adjustments, it is triggered in the rate cases when the benchmark-relative reduction in index WACI falls below 35%. WACI is targeted because it is the carbon metric that the Taskforce on Climate-related Financial Disclosures recommends asset owners and managers report as a first step (TCFD, 2017).

Figure 1 below illustrates how this triple decarbonisation approach is incorporated into flagship index construction.

Figure 1: Low Carbon High Factor Intensity Multi-Smart-Factor Index Construction Steps

ESG Incorporation Philosophy, ESG Exclusions and Decarbonisation Approaches

ESG Incorporation Philosophy

The respect of this philosophy allows the Low Carbon option to demonstrate unambiguous support for the transition to a low carbon economy, reduce exposure to Transition Risk and protect investment performance. Divestment from companies involved with particularly inefficient fuels or high Carbon Intensity contributes to increasing their cost of capital and incentivises transition by these companies and others. Reduced exposure to companies facing high levels of Stranding Risk or overall Transition Risk promotes the resilience of the index to Climate Change. In the absence of sound academic evidence documenting the existence of non-redundant ESG performance factors, dealing with ESG concerns or risks as a first step allows downstream index construction to concentrate on the assumption of rewarded systematic risks through factor-based security selection and the mitigation of conventional risks through the application of diversification weighting schemes to address unrewarded idiosyncratic risk and the imposition of risk controls on non-diversifiable risks through weight adjustments.

Negative Exclusion of Coal Companies and Other Core ESG Filter Exclusions

The coal involvement filter is part of the Core ESG filter that is embedded in all of Scientific Beta's off-the-shelf ESG Options. Anchored in international norms, this Core ESG filter is a collection of negative screens that span consensual product-based and conduct-based exclusions.

The bulk of the exclusions as per the Core ESG filter are in respect of coal companies as defined in Table 1 below.

Table 1: Coal-Involvement Filter of the Low Carbon Fiduciary Option

From an ethical and socially responsible investment standpoint, the focus on Coal is mandated by it being the largest source of electricity and the conventional fuel with the lowest heating value normalised by GHG emissions. In the 1.5 degree scenarios of the Intergovernmental Panel on Climate Change (IPCC), the median reduction in coal use between 2020 and 2050 is 85% and as far as energy generation is concerned, the median reduction in coal usage is 96% (IPCC, 2018).

Divestment of companies with a major role in the supply and demand for coal is not only consistent with a deontological approach, but by sending a clear signal to stakeholders and possibly increasing the cost of capital through reduced demand for securities (directly through divestment and indirectly by the promotion of increased uncertainty with respect to valuations), it also incentivises transition towards less environmentally harmful activities and technologies on the part of shunned and other companies.

From the point of view of potential financial materiality of ESG risks, the above figures suggest that coal-mining and coal usage, especially for energy production need to be drastically curtailed. If the transition is faster or more severe than the scenarios reflected in corporate accounts and earnings forecasts, the book value and/or the earning potential of coal assets will be impaired. If such impairments are not correctly anticipated by the average investor, coal companies will be repriced on the markets. Mitigating this risk of stranding can provide a financial motive for divestment.

While targeting coal in general, the exclusions focus on thermal coal as, in the medium-term, there is no economically-relevant at-scale substitute for metallurgical coal used for iron and steel manufacturing. The 30% threshold used in respect of thermal coal revenues and coal-fired power generation capacity is aligned with the current practices of leading asset owners and the expectations of major divestment campaigns.

Filtering out the stocks with significant coal involvement guarantees zero exposure to these stocks in all derived indices. It also promotes reductions in the emissions-based carbon metrics of derived indices as coal-fired power generation typically makes an outsized contribution to these metrics.

Positive Exclusion of High Carbon Intensity Companies

The second decarbonisation approach implements a region-neutral flexible best-in-class filter that excludes companies with high Carbon Intensity, i.e. greenhouse gas emissions to corporate revenues while protecting sector representation in each region. The emissions considered are direct corporate emissions, i.e. emissions from sources that are owned and/or controlled by the company, plus indirect emissions from the generation of electricity, steam, heating or cooling purchased/consumed by the company (Scope 1 and 2 emissions, respectively). Other indirect emissions that occur upstream (in relation to purchased goods and services) or downstream (distribution and use of the company's products and services) as reporting in respect of these (Scope 3 emissions) is seriously lacking and estimation models are insufficiently granular for stock-level decisions.

From a non-financial point of view, this approach to decarbonisation recognises that the transition to a low carbon economy goes beyond phasing out thermal coal and that carbon efficiency should be incentivised in key sectors and beyond. From the point of view of ESG risks with potential financial materiality, it acknowledges that Transition Risk pervades key transition sectors, e.g. Energy – Fossil Fuels, Utilities, Basic Materials (e.g. steel, cement), Transportation, Real Estate, and affects high carbon intensity companies across all sectors.

The filter ranks constituents in each region according to company level Carbon Intensity and exclusion proceeds strictly from worst (highest) to best (lowest) subject to sector rules, notably a 50% cap in the number of exclusions. Relative to a sector-neutral approach, the filter promotes materially higher impact for a given exclusion budget. This budget is set at 10% of the number of securities in each region.

Table 2: Carbon-Intensity Filter of the Low Carbon Fiduciary Option

The regional neutrality, sector protection and exclusion efficiency features of the Low Carbon filter allow to build indices that are aligned with their parents in terms of geographic exposure; preserve wide sector representation in standard indices and the ability to build sector-controlled indices; and protect the geographic and sector dimensions of rewarded factor exposures and the potential for idiosyncratic risk reduction by the application of diversification weighting schemes to a diverse pool of securities.

Filtering out the stocks with the highest Carbon Intensities, subject to sector controls, guarantees zero exposure to these stocks in all derived indices. It also promotes reductions in the emissions-based carbon metrics of derived indices, notably the portfolio-level Carbon Intensity – a carbon footprinting measure that normalises the sum of the indirect emissions owned by the investor by the sum of the corporate revenues owned (with ownership being in proportion to the share of the capital controlled by the portfolio) – and the portfolio-weighted average of constituent-level Carbon Intensities (WACI).

Weighted Average Carbon Intensity Shortfall Reduction

The Coal involvement and Carbon Intensity filters jointly remove the companies most exposed to Transition Risks from any derived index. This exclusionary approach typically promotes improved portfolio-wide average carbon metrics for derived multi-smart-factor indices relative to the levels produced by applying the same index construction methodologies to unfiltered universes. However, in keeping with the ESG incorporation philosophy of Scientific Beta, these portfolio averages are by-products of the screening and index construction methodologies rather than objectives or constraints determining individual security selection and weighting. It follows naturally that the levels of these metrics vary over time.

To protect long-term investment strategies tracking multi-smart-factor indices against questioning in respect of adverse short-term deviations of carbon metrics used by investors for reporting, the Low Carbon fiduciary option embeds a conditional shortfall reduction mechanism. The mechanism is activated when the WACI of the multi-smart-factor index to which the fiduciary option is applied fails to achieve a reduction of 35% relative to that of the benchmark. This trigger threshold was calibrated historically to ensure that adjustments would remain rare. In each region where there is a shortfall, the adjustment algorithm compares various ways of reallocating index weights from higher to lower WACI Economic Sectors to minimise the shortfall; as noted in Table 4 below, adjustments are highly constrained to preserve the financial characteristics of the index (and limit turnover).

Table 3: Weighted Average Carbon Intensity Shortfall Reduction of the Low Carbon Fiduciary Option

Historically, the United States is the region in which the mechanism is most often triggered for the Low Carbon version of the flagship HFI MBMS Six-Factor Index (Equal-Weighted). Figure 2 below illustrates the variability of the relative WACI decarbonisation over the ten years ended December 2018 and displays both the pre-adjustment WACI and the final index WACI to highlight the quarters in which the index required adjustment.

Figure 2: WACI of United States Low Carbon HFI Multi-Beta 6-Factor Index (Equal-Weighted), 2009-2018

Risks and Performances of Low Carbon Multi-Smart-Factor Indices

Decarbonisation Performance

Fossil Fuel Involvement and Carbon Asset Stranding Risk Metrics

In the assessment of stranding risk, we pay particular attention to the fossil fuel and power generation sectors.

Examining exposure to fossil fuel companies, we see that filtering leads to indices in which pure coal players are removed and exposure to companies with significant turnover from fossil fuels is reduced, including in the sector controlled version of the index.

Table 4: Fossil Fuel Sector Exposure for Various Indices, Developed Universe, 10-year Averages

To assess stranding risk in the fossil fuel sector, it is also relevant to look at reserved emissions, i.e. the greenhouse gas emissions associated with the fossil-fuel reserves of portfolio constituents. Table 5 below presents these reserves normalised in millions of tons of CO2 (per USD billion invested); because stranding is understood to materially differ on the basis of the fossil fuel, the top figure is disaggregated into coal on one hand and oil and gas on the other. Due to data limitations, we present the latest figures.

Table 5 below confirms that the Core ESG filter reduces normalised potential emissions from the burning of coal owned by universe constituents by over 90%. While exposure to Oil and Gas reserves is not controlled (and may increase as a result of reallocation across sectors in the absence of sector control or within sectors in its presence), the net impact, for Developed Markets, is a material reduction in overall reserved emissions.

Table 5: Potential Emissions Associated with Reserves, Various Indices, Developed Universe, December 2018

Table 6 below reports the weight, fuel mix and carbon efficiency of power-generating Utilities in the same indices at December 2018.

While the multifactor index construction methodology favours power-generating Utilities, the Low Carbon version of the index has materially lower exposure to these assets relative to the benchmark, including when sector control is imposed. More interestingly, filtering is found to materially reduce the weight of coal in the fuel mix of the power-generating Utilities in the index. While we observe an amount of substitution amongst "fossil fuels" (defined as coal plus oil and gas) towards cleaner fuels, the share of these fuels, also known as "brown share," is also reduced.

Table 6: Exposure to Power-Generating Utilities for Various Indices, Developed Universe, End of 2018

All in all, the Low Carbon option materially reduces the exposure to Transition Risk associated with power generation by reducing the importance of power-generation in the index and tilting the fuel mix of this group of constituents materially away from coal.

TCFD Carbon Metrics

Table 7 reports the normalised carbon footprinting and other exposure metrics that the TCFD considers of interest for reporting. Figures are averaged over 10 years.

The application of the Low Carbon option produces excellent decarbonisation as measured by carbon footprinting metrics (Carbon Intensity as introduced earlier as Carbon Footprint, which normalises owned emissions by current investment value) and Weighted Average Carbon Intensity. This suggests that the Low Carbon indices are associated with materially lower indirect contributions to Climate Change and materially reduced exposure to companies with potential high risk of exposure to Transition Risks. For illustration, the WACI of the Developed Low Carbon HFI MBMS 6 Factor (Equal-Weighted) index is less than 30% of that of its unfiltered counterpart and less than half that of the benchmark. Emissions-based metrics are also excellent for the sector-controlled version of the indices, which suggest that the reduction is not explained away by sector allocations. Notably, the WACI of the sector-neutral version of the Developed Low Carbon multifactor index is less than half (43%) that of its unfiltered counterpart and about half (49%) that of the benchmark. While the emissions-based decarbonisation of the universe is based on Scope 1+2 data only, we observe that decarbonisation in respect of Total Emissions, which also include Scope 3 emissions, is material.

Table 7 also shows that the exposure to Carbon Assets, i.e. companies in the Fossil Fuels sector and Fossil Fuel Electric Utilities, is reduced, including when the index is subjected to sector control (at the higher level of Ecomomic Sectors). More interestingly and as previously observed, index constituents from these sectors are materially less carbon intensive than the average of their peers, when the opposite is true for the standard indices.

Table 7: TCFD Carbon Metrics for Various Indices, Developed Universe, 10-year Averages

Financial Risks and Performance

Factor Exposures and Deconcentration as Sources of Performance

The two sources of long-term benchmark-relative outperformance that the Scientific Beta multi smart factor index methodology exploits are the exposure to rewarded risk factors beyond the broad equity market factor and improved diversification of idiosyncratic risk.

Table 8 presents the regression coefficients of derived indices for the CAPM and the seven factor model. The application of the coal-involvement filter reduces availability of (power generating) Utilities, a source of Low Volatility exposure in Developed Markets; this leads to a decrease in the exposure to the Low Volatility factor in the derived indices in the absence of sector control. Filtering also leads to higher exposure to High Profitability in derived indices irrespective of sector control, which is a typical observation with ESG filtering. Altogether, Developed Low Carbon multifactor indices have slightly higher factor intensity than their unfiltered counterparts. Interestingly, there is no evidence of abnormal performance once factors are recognised. In other words, the historical record does not support the idea that the decarbonisation and other ESG filters applied to the Developed universe add to or subtract from the performance of derived indices once loadings on consensual factors are accounted for.

Table 8: Factor Exposures in CAPM and 7 Factor Model for Various Indices, Developed Universe, 10 years

Table 9 presents the number of constituents and the effective number of constituents of derived indices. Numbers fall in line with the number of exclusions and all derived indices built from filtered universes remain significantly more deconcentrated than the benchmark, leaving good potential for diversification of idiosyncratic risk.

Table 9: Number of Constituents and Deconcentration of Various Indices, Developed Universe, December 2018

Risks and Performance Statistics

Table 10 below presents the performance and risk-adjusted performance of the standard and Low Carbon versions of the flagship indices over the last ten years.

In Developed Markets and in the absence of sector control, the Low Carbon versions of the indices have marginally better performance and risk-adjusted performance than their counterparts built from the unfiltered universe; no such difference is observed with sector control.

Table 10: Performance, Risk Adjusted Performance and Conditionality of Various Indices, Developed Universe, 10 years

Conclusion

The Low Carbon fiduciary option applicable across Scientific Beta's flagship offering allows ethical and socially responsible investors to dissociate from companies with significant coal involvement and further promote the transition to a low carbon economy by reorienting their investments towards less carbon-intensive activities and companies. From a socially responsible investment perspective, the benefits of this reallocation are demonstrated by the material reductions in the coal-asset exposure of derived indices and in the carbon footprints of these indices, notably as measured by financed emissions to financed revenues. Because it relies on an approach that determines potential inclusion into derived indices based solely on the coal involvement of each firm and its carbon intensity relative to peers, the Low Carbon fiduciary option sends clear signals to issuers regarding the urgency of decarbonising their operations and is straightforward to explain to beneficiaries, clients and other stakeholders; this compares positively to optimisation approaches that may consider an issuer's carbon profile as one of multiple criteria for selection and/or may engineer an attractive portfolio-wide carbon metric while allowing for the presence and possibly overweighting of firms with particularly poor carbon profiles.

By delivering a drastic reduction of exposure both to coal assets, which may become stranded in the transition to a low carbon economy and to the most carbon-intensive companies, the Low Carbon fiduciary option produces derived indices with higher resilience to Transition Risks relative not only to standard multifactor indices but also to parent universe benchmarks. Derived indices also boast benchmark-relative reductions in respect of Weighted Average Carbon Intensity, the carbon exposure metric recommended by the TCFD for reporting by asset managers and asset owners, of circa 50% over the last ten years. As such, they are also particularly relevant for investors that wish to implement multifactor investment strategies but recognise that Climate Change risks may materially impact portfolio values and wish to apply ambitious mitigation of these risks as a precaution.

Over the last ten years, the multifactor indices to which the Low Carbon fiduciary option has been applied are found to protect the sources of financial outperformance of the Scientific Beta multi smart-factor offering and typically perform in line with their unfiltered counterparts; supporting the transition to a low carbon economy and protecting against the risks of this transition had no meaningful impact on financial performance.

References:

Intergovernmental Panel on Climate Change (IPCC), 2014. Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, R.K. Pachauri and L.A. Meyer (eds.)]. IPCC, Geneva, Switzerland, 151 pp.
Intergovernmental Panel on Climate Change (IPCC), 2018. Summary for Policymakers. In: Global Warming of 1.5°C. An IPCC Special Report on the impacts of global warming of 1.5°C above pre-industrial levels and related global greenhouse gas emission pathways, in the context of strengthening the global response to the threat of climate change, sustainable development, and efforts to eradicate poverty [V. Masson-Delmotte, P. Zhai, H.-O. Pörtner, D. Roberts, J. Skea, P.R. Shukla, A. Pirani, W. Moufouma-Okia, C. Péan, R. Pidcock, S. Connors, J.B.R. Matthews, Y. Chen, X. Zhou, M.I. Gomis, E. Lonnoy, Maycock, M. Tignor, and T. Waterfield (eds.)]. World Meteorological Organization, Geneva, Switzerland, 32 pp, available at https://www.ipcc.ch/sr15/.
Task Force on Climate-related Financial Disclosures (TCFD), 2017. Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, Financial Stability Board, available at https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-TCFD-Annex-062817.pdf.

Scientific Beta Low Carbon Option – Supporting the Transition to a Low Carbon Economy and Protecting Multifactor Indices against Transition Risks, Scientific Beta white paper, June 2019

Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of ESG Norms and Climate Change Issues in Investment Management

The incorporation of Environmental, Social and Governance (ESG) dimensions into investment analysis and decision-making processes and reporting has traditionally been optional and a low priority for most institutional investors. However, this is changing rapidly owing to both push and pull factors. On the one hand, institutional investors are increasingly required, or expected, to explain how they factor ESG dimensions into investment decisions and to report on their ESG incorporation processes and the ESG performance of their investments. On the other hand, a growing number of institutional investors consider that the ESG characteristics of investments may have a material impact on investment risks and returns or recognise that an increasing share of end-investors wish to see the environmental and social impacts of investments being considered together with their financial characteristics.

As business-case investors incorporating ESG dimensions to enhance returns and/or strengthen risk management join traditional values-based investors imposing non-financial constraints and/or objectives to align their investments with personal values or social norms, the motivations for incorporating ESG data into investment management have never been so diverse.

Scientific Beta recognises the diversity of these motivations and its ESG and Low Carbon Fiduciary Options, as well as the Enhanced ESG Reporting, are designed to serve the needs of ethical and socially responsible investors as well as those of business-case ESG investors.

Since inception, Scientific Beta has been offering unparalleled transparency on the financial risks and performances of its indices along with fiduciary options allowing investors to control non-diversifiable risks. The Enhanced ESG Reporting, along with the ESG and Low Carbon Fiduciary Options also introduced in July 2019, extend this tradition into the ESG space.

Specifically, the objective of Scientific Beta's Enhanced ESG reporting is to assist investors with the incorporation of ESG dimensions into their investment analysis and decision-making processes as well as their mandatory and voluntary disclosures.

The Scientific Beta Enhanced ESG Reporting includes over a dozen reports covering ESG Norms and Climate Change and is offered on a complimentary basis and available not only for ESG and Low Carbon Option indices but across the entire index offering. It is relevant to investors whose ESG objectives or constraints may include one or several of the following:

Discharging of ESG reporting obligations;
Dissociating from companies involved in controversial products and conducts;
Incentivising the respect of global norms and/or the transition to a low-carbon economy;
Improving investment resilience to climate change;
Shunning investments that could create reputational and liability risks;
Altering the expected risk/return profile of the portfolio by avoiding companies whose ESG performances may expose the portfolio to material adverse financial impacts.

ESG Norms Reporting

Scientific Beta's ESG Norms analytics measure index exposure to companies with involvement in products that conflict with global ESG norms or their objectives and to companies whose conduct violates fundamental ethical or corporate governance norms.

Such assessments have relevance for ethical and socially responsible investors as well as for business-as-usual investors as shown in Table 1.

Table 1: Possible Motivations for Analysing Respect of Global Norms

Responsible Business Conduct and Corporate Governance Norms and Analytics

Responsible Business Conduct: Ethical Norms Report

There are two international initiatives that define principles of responsible business conduct by drawing on international conventions and declarations with (quasi) universal consensus:

Launched in 2000, the United Nations Global Compact ("Global Compact") is the world's most successful voluntary corporate responsibility initiative;
Originally issued in 1976 and regularly updated, the OECD Guidelines for Multinational Enterprises are government recommendations to multinationals operating in or from adhering countries (48 such countries as at July 2019).

Scientific Beta relies on the UN Global Compact as the main reference because of its scope and simplicity. The UN Global Compact Ten Principles are derived from the Universal Declaration of Human Rights, the International Labour Organisation's Declaration on Fundamental Principles and Rights at Work, (1998, review 2010), the Rio Declaration on Environment and Development (1992) and the United Nations Convention Against Corruption (2005).

The Ethical Norms Report tracks (i) exposure to companies that present high risk of future gross violations of fundamental ethical norms and (ii) exposure to companies that are facing critical ESG controversies in respect of their fundamental responsibilities.

Table 2: Ethical Norms Report for Sample Flagship Index at End June 2018

To measure the risk of gross violations of fundamental norms, we rely on the public and substantiated exclusion list prepared by the Central Bank of Norway ("Bank") for the management of the country's Government Pension Fund Global. The Bank's framework reasonably maps the Ten Principles of the Global Compact. When deciding upon exclusions, the Bank is required to consider the exercise of ownership rights or other measures that may be more suited to reduce the risk of continued norm violations and authorised to consider the probability of future norm violations. The latter may be informed by the quality of the company's risk management architecture and by how the company is responding to ESG controversies and notably whether it is putting forward remediating or corrective measures as well as preventative measures. Being concerned with grossly unethical conduct, framed in a consequentialist approach, and made to integrate forward-looking and risk-management considerations, the Bank's exclusions are necessarily limited. Their objective is not to implement a reaction to past corporate transgressions but to serve as a defence mechanism for the investor against the risk of complicity in unacceptable practices going forward.

By contrast, our tracking of companies facing critical ESG controversies in respect of their fundamental responsibilities is based solely on past transgressions and disregards the response of the company and the frequency of controversies. A critical controversy relates to a fundamental issue and has high adverse impact on a large scope and fundamental issues are in relation to the four areas covered by the Global Compact as above, i.e. human rights, labour, environment and anti-corruption. Controversy screening and criticality assessment are performed by Vigeo-Eiris. Added to this list are companies ineligible to join the Global Compact, which notably include those that are subject to a United Nations (UN) sanction or listed on the UN Ineligible Vendors List for ethical reasons.

Corporate Governance Norms: Non-voting Shares Report

Proportionality between corporate ownership and control protects all shareholders against conflicts of interest and is expected to promote good corporate performance and market efficiency via internal and external (i.e. the market for corporate ownership and control) mechanisms.

The issuance of multiple share classes and the reliance on cascading shareholdings are the main, age-old, mechanisms to leverage the power of certain shareholders to the detriment of others.

There has been considerable interest in multiple-class share structures recently due to their resurgence and growing usage, notably by technology companies, starting with Google in 2004, and in the wake of excesses such as the 2017 decision by Snap Inc. to only list non-voting shares. In this context, concerned U.S. investor groups have lobbied stock exchanges to impose restrictions on multiple class structures and index providers to look into excluding non-voting shares.

The G20/OECD Principles of Corporate Governance, which are the leading corporate governance benchmark endorsed by governments, recognise voting rights as one of the basic shareholder rights but do not require proportionality.

Against this backdrop, the Non-Voting Shares Report measures the cumulated weight of index constituents issued by companies that only offer non-voting stocks to the public.

Table 3: Non-Voting Shares Report for Sample Flagship Index at End June 2018

Norms and Analytics Covering Controversial Products and Activities

Global norms in respect of prohibited and restricted activities centre on weapons that violate fundamental humanitarian principles through their normal use due to their disproportionate or indiscriminate impact (hereafter "Controversial Weapons"). Activity or product-based exclusions in relation to global norms may go beyond the strict respect of the letter of a treaty and target companies whose activities or products are fundamentally at odds with the ESG objectives pursued by the treaty. In this regard, we focus on two areas of strong institutional investor interest – tobacco and climate change – for which global norms with close to universal support exist.

Legally binding in 181 countries (out of 195), the 2003 World Health Organization (WHO) Framework Convention on Tobacco Control aims "to protect present and future generations from the devastating health, social, environmental and economic consequences of tobacco consumption and exposure to tobacco smoke by providing a framework for tobacco control measures (…) in order to reduce continually and substantially the prevalence of tobacco use and exposure to tobacco smoke."

Ratified by all the member states of the United Nations, the 1992 United Nations Framework Convention on Climate Change aims for the "stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system". Ratified by 185 Parties to the Convention (out of 197), the 2015 Paris Agreement has as its first aim to hold the increase in the average global temperature well below two degrees Celsius above pre-industrial levels and pursuing efforts to target an increase of 1.5 degrees Celsius.

Institutional investment in respect of tobacco and climate change is demonstrated by fund flows: tobacco screening has recorded the fastest growth amongst exclusions in recent years and is now the most popular screen globally (GSIA, 2019; Eurosif, 2018) while fossil fuel divestment registers high interest globally and climate change is the second ESG theme in the US responsible investment industry by assets to which it is applied (US SIF, 2018).

Controversial Weapons Report

The Controversial Weapons Report measures the cumulated weight of index constituents whose issuers are involved in controversial weapons in general and in two groups of such weapons in particular:

Anti-Personnel Landmines and Cluster Munitions have been the subject of successful international campaigns, which have made them widely reviled amongst the public and have led to several countries prohibiting financial institutions from investing directly or indirectly in companies involved in these weapons and to investors voluntarily adopting these investment prohibitions. Note that involvement in these weapons disqualifies a company for recognition as a participant in the UN Global Compact.
Weapons of Mass Destruction, i.e. Nuclear, Bacteriological and Chemical (NBC) weapons are those most often excluded voluntarily by investors after Anti-Personnel Landmines and Cluster Munitions; while some investors limit the exclusion in respect of Nuclear weapons to those companies in breach of the Non-Proliferation Treaty, a growing numbers of investors extend the prohibition to all companies with involvement in Nuclear weapons.

Table 4: Controversial Weapons Report for Sample Flagship Index at End June 2018

Public sources and Vigeo-Eiris data are used to produce this report.

Tobacco Report

This report tracks exposure to Tobacco Industry companies and companies with involvement in the production of tobacco regardless of the percentage of revenues represented by this activity and exposure to companies that derive more than 5% of their revenues from the production or distribution of tobacco. Public sources are relied upon for the former assessment and Vigeo-Eiris data are used for the latter.

Table 5: Tobacco Report for Sample Flagship index at End June 2018

Involvement in the production of tobacco products concerns only complete tobacco products, which corresponds to the definition of involvement adopted by the Tobacco-Free Finance Pledge (2018) and is consistent with the definition disqualifying a company for recognition as a participant in the UN Global Compact (2017).

Coal Report

This report tracks exposure to companies with significant involvement in coal as per industry classification, turnover, and ownership of reserves or, in the case of Utilities, usage for power generation.

The rapid phasing out of coal is key to averting the climate catastrophe. McGlade and Ekins (2015) estimate that 82% of coal reserves need to remain unburned before 2050 in the 2-degree scenario. In this context, coal-powered plants and the entire coal supply chain face high exposure to stranding risk.

Table 6: Coal Report for Sample Flagship Index at June 2018

In the medium-term, there is no economically-relevant at-scale substitute for metallurgical coal used for iron and steel manufacturing, hence we focus on thermal coal and disregard companies with Iron & Steel industry classification for the coal reserves analytics.

Climate Change Reporting

Climate Change reports look into the greenhouse gas emissions associated with the operations of index constituents and provide indicators of relevance to the assessment of potential impacts of climate change on the values of portfolio holdings. Impact may be from physical effects – of an acute nature (e.g. damage to assets or supply chain disruptions due to climate events) or a chronic nature (e.g. changes to resource availability or productivity, increase in temperatures or sea level); from regulatory, technology and market changes brought about by the need to mitigate the effects of climate change and transition to a low greenhouse gas economy or from climate change-related litigation (e.g. in relation to a company's failure to mitigate climate change or adapt to it, of insufficient climate change disclosure). Impacts may be through revenues, expenditures, assets and liabilities, and access to funding.

It is typical to classify Climate Change Risks into Physical Risks and Transition Risks, with the latter including Litigation Risks. Stranding Risk, the risk of early or unexpected asset impairment or conversion to liability as a result of climate change is usually considered only in the context of the risks of the transition to a low carbon economy.

Scientific Beta Climate Change reporting is meant to support analysis and reporting in regards to contribution to Climate Change; overall exposure to Transition Risks and Stranding Risks; and exposure to Physical Risks.

Measuring Contribution to Climate Change

Carbon Footprinting Report

Carbon Footprinting entails allocating to the portfolio a share of the greenhouse gas emissions of each holding in proportion to the share of its capital that is controlled by the portfolio. As such, it measures the indirect responsibility of a portfolio's investor in respect of emissions.

Corporate emissions are assessed in respect of three scopes as shown in Table 7. Because, self-reported Scope 3 data is sparse and lacking in quality, assessment of Scope 3 emissions relies on modelling and company to company comparisons are typically based on metrics computed from Scope 1 and 2 data. All emissions data are sourced from Institutional Shareholder Services.

Table 7: Scopes of Greenhouse Gas (GHG) Emissions

The three most common carbon footprinting metrics are: Total Emissions, Carbon Footprint and Carbon Intensity. Total Emissions represents the absolute footprint of the portfolio, whereas Carbon Footprint normalises Total Emissions by the current market value of the portfolio and Carbon Intensity by the revenues controlled by the portfolio.

Table 8: Carbon Footprinting Report for Sample Flagship Index at December 2018

Total Emissions are provided for the capitalisation-weighted index of the parent universe under the assumption of ownership of the entire free-float of each index constituent, an assumption that is broadly consistent with the weighting scheme of the index. No such assumption can be made for alternative-weighted indices to determine a level of investment and the corresponding figure for Total Emissions.

Assessing Exposure to Transition Risks

Carbon Exposure Report

This report measures portfolio exposure to carbon-intensive companies and sectors though two metrics:

Weighted Average Carbon Intensity (WACI), which is the portfolio-weighted average of constituent-level Carbon Intensities and the carbon metric that the Taskforce on Climate-related Financial Disclosures recommends for portfolio reporting (TCFD, 2017).
Exposure to Carbon-related Assets, which is the combined exposure to the fossil fuel sector and fossil-fuelled fired Utilities sector.

While a measure of exposure to carbon-intensive companies, WACI is often used as a proxy for exposure to carbon-price risk. Because Exposure to Carbon-related Assets relates to assets that are particularly at risk in the transition to a low carbon economy, it is typically used for broad-brush estimation of stranding risk in the portfolio. To promote a finer-grain understanding of exposure, Scientific Beta breakdowns exposure into sub-sectors and reports WACI for each category.

Table 9: Carbon Exposure Report for Sample Flagship Index at End June 2018

WACI Decomposition Report

WACI Decomposition is a single-period, holding-based method which, in the spirit of Brinson, Hood and Beebower (1986), breaks down the WACI of the index relative to that of its cap-weighted reference into sector-weighting, intra-sector stock-selection and interaction effects. This decomposition sheds light on the quality of a portfolio's decarbonisation.

Table 10: WACI Decomposition for Sample Flagship Index at End June 2018

In the example of Table 10, the reduction in WACI relative to the benchmark results from a positive stock-selection effect (112%), a negative sector effect (-27%) and a positive interaction effect (15%); this illustrates that the decarbonisation is not achieved by the underweighting of carbon intensive sectors but despite overweighting these.

Deep-Dive into Carbon-Related Assets: Reserved Emissions, Fossil Fuels and Power Generation Reports

Deep-dive reporting into carbon-related assets allows for finer-grain assessment of investment exposure to assets and sectors with high stranding risk potential due to their involvement in fossil fuels, on the supply or demand sides.

Reserved Emissions Report

This report shows the potential carbon dioxide emissions associated with the burning of fossil-fuel reserves controlled by an investment portfolio. In the absence of corporate disclosures of reserved emissions, these are estimated from reserves figures that are reported by, or attributed to, companies. These emissions are normalised by investment value and disaggregated into emissions from Coal reserves vs. emissions from Oil and Gas reserves (including Natural Gas Liquids and Bitumen) because the stranding risk of the former is materially higher than that of the latter. Reserved emissions data are sourced from Institutional Shareholder Services.

Table 11: Reserved Emissions Report for Sample Flagship Index at End June 2018

Fossil Fuels Report

This report measures investment exposure to the fossil fuels industry and companies with significant fossil fuel involvement, in aggregate and for specific fuels. Exposure is measured according to industry classification and turnover from fossil fuels. Data for computation of the latter are sourced from Institutional Shareholder Services. To promote a finer-grain understanding of exposure, Scientific Beta breakdowns exposure into sub-sectors and reports WACI for each category.

Table 12: Fossil Fuels Report for Sample Flagship Index at End June 2018

Power Generation Report

Scientific Beta reports the cumulated percentage weight of index constituents from the Utilities and Financials sectors that generate power along with the power-generation capacity that they command and their capacity-weighted fuel mix. The Weighted Average Carbon Intensity of this group of assets is also reported to support finer grain analyses.

Table 13: Power Generation Report for Sample Flagship Index at End June 2018

Scientific Beta reports the cumulated percentage weight of index constituents from the Utilities and Financials sectors that generate power along with the power-generation capacity that they command (for a USD1bn investment in the index) and their capacity-weighted fuel mix.

Assessing Exposure to Physical Risks

Physical Risks Report

This report presents the estimated exposure of index constituents to the long-term and acute physical risks from climate change. The assessment of physical risk exposure at index-constituent level is based on a sector and geographic approach. Based on its main field of activity, a company is allocated to a sector in the proprietary classification system of the data provider and attributed the corresponding risk level. This assessment is sourced from Institutional Shareholder Services.

Table 14: Carbon Exposure Report for Sample Flagship Index at End June 2018

Conclusion

Scientific Beta's Enhanced ESG Reporting, which is offered on a complimentary basis across the index offering, demonstrates Scientific Beta's commitment to transparency on the risks of its index strategies and to assisting investors in meeting the challenges and seizing the opportunities of ESG incorporation in investment management.

The ESG Norms analytics measure index exposure to companies that are found to fall short of global standards of responsible business conduct and corporate governance or to have involvement in activities that conflict with global norms or their objectives.

The Climate Change Analytics support assessments of the indirect contribution of index-tracking portfolios to Climate Change, assessment of index exposure to companies and sectors with high potential to Transition Risks, and assessment of index constituent exposure to Physical Risks.

Scientific Beta's researchers have accompanied investors with the incorporation of ESG objectives and constraints in passive investment for ten years and a third of the assets tracking Scientific Beta indices track indices that incorporate ESG dimensions.

Scientific Beta's Enhanced ESG Reporting is thus available for the whole range of Scientific Beta indices, including those without fees based on ESG or Low Carbon options. This approach, based on transparency and free access to information pertaining to ESG and climate risk, is our contribution to a collective effort to build a better world. ESG and climate risk mitigation must not only represent good business for solution providers but also for the planet!

References:

Brinson, G. P., L. R. Hood and G. L. Beebower, 1986. Determinants of Portfolio Performance. Financial Analysts Journal, Volume 42, Issue 4, pp. 39-44.
Eurosif, 2018. EUROPEAN SRI STUDY 2018. EUROSIF A.I.S.B.L. European Sustainable Investment Forum, Brussels, available at: http://www.eurosif.org/wp-content/uploads/2018/11/European-SRI-2018-Study-LR.pdf.
GSIA, 2019. Global Sustainable Investment Review 2018, available at: http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf.
McGlade, C. and P. Ekins, 2015. The geographical distribution of fossil fuels unused when limiting global warming to 2 °C. Nature, Volume 517, pp. 187–190.
US SIF, 2018. Report on US Sustainable, Responsible and Impact Investing Trends – 2018 Trends Report Highlights, US SIF, available at: https://www.ussif.org/files/2018%20_Trends_OnePager_Overview(2).pdf.
Task Force on Climate-related Financial Disclosures (TCFD), 2017. Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, Financial Stability Board, available at https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-TCFD-Annex-062817.pdf.

Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of ESG Norms and Climate Change Issues in Investment Management, Scientific Beta white paper, July 2019

The Risks of Deviating from Academically-Validated Factors

A webinar hosted by Felix Goltz, Research Director at Scientific Beta, on 13 June, 2019 discussed factor definitions used in investment products and analytic tools offered to investors and contrasted them with the standard academic factors. It also outlined why the methodologies used in practice pose a high risk of ending up with irrelevant factors.

Factor investing has never been as popular as it is today. However, with the propagation of this type of investment approach, the equity space is becoming increasingly saturated with more and more factors that are ever more removed from academically-grounded research. In a bid to maintain their apparent competitive advantage and to show that they are still delivering alpha, commercial index providers and asset managers have respectively embarked on a factor finding process that has resulted in the discovery of tens, hundreds or even thousands of factors. However, proprietary factor definitions and analytic toolkits based on non-standard factor indices can lead to unintended exposures and misunderstandings surrounding the associated risk exposures. The further away they are from academically-validated research, the more spurious and redundant proprietary factor definitions may be.

The Risks of Deviating from Academically-Validated Factors, Scientific Beta white paper, February 2019

Interview with Frédéric Ducoulombier, ESG Director, Scientific Beta

In this interview, Frederic Ducoulombier, ESG Director at Scientific Beta, discusses the launch of the Enhanced ESG Reporting and ESG and Low Carbon Fiduciary Options and how Scientific Beta's ESG incorporation philosophy fits in the evolving ESG investment space.

Why is Scientific Beta launching Enhanced ESG Reporting on its indices and introducing ESG Fiduciary Options?

Since inception, Scientific Beta has been offering full transparency on the financial risks and performances of its indices along with fiduciary options allowing investors to control non-diversifiable risks. The Enhanced ESG Reporting, along with the ESG and Low Carbon Fiduciary Options, extend this tradition into the ESG space.

The Enhanced ESG Reporting is meant to support decision making and reporting in respect of indices. It includes over a dozen reports covering ESG Norms and Climate Change and is offered on a complimentary basis across the entire index offering. ESG Norms Reporting gives investors transparency on index exposure to companies that fail global norms of responsible business conduct and governance or that are involved in activities that conflict with global norms or their objectives in key areas of interest to investors. Climate Change reporting includes assessments of the indirect contribution of index-linked investments to climate change, of exposure to companies, sectors and assets that are particularly at risk of adverse disruption in the transition to a low carbon economy and of exposure to companies that are facing different degrees of disruption due to the physical risks of climate change.

While Scientific Beta researchers have been helping investors with the incorporation of ESG dimensions into passive investments for ten years in the context of custom mandates and dedicated indices, the ESG and Low Carbon Fiduciary Options are meant to facilitate this integration into our flagship offering. Indeed, these options are applicable across the entire High Factor Intensity multi-smart factor offering and can be combined with the Sector Neutral and Market Beta Adjustment options. The Low Carbon Fiduciary Option reduces allocation to coal assets and carbon-intensive companies across sectors to support the transition to a low carbon economy, reduce contribution to climate change and improve resilience to the risks of the transition. The ESG Fiduciary Option focuses on the removal of companies that fail high standards of responsible business conduct and corporate governance or engage in activities that conflict with global ESG norms or their objectives. As such it promotes adherence to high ESG standards, reduces investor reputational risk and reduces exposure to companies whose ESG performances may have a detrimental financial impact on the portfolio.

How does Scientific Beta view the evolution of practices in terms of ESG incorporation and the future of responsible investing?

ESG incorporation started with faith-based exclusions of sin stocks and diversified in the second half of the twentieth century with the advent of Socially Responsible Investing, an approach that relies on both financial and ESG characteristics to build portfolios with progressive ESG agendas. In an effort to develop demand for Socially Responsible Investing, some of its advocates introduced the promise of outperformance to try and address the concerns of fiduciaries that lacked a clear mandate to adopt ESG progressive strategies if this involved non-competitive risk-adjusted returns and lure business-as-usual investors. This had limited success, leading promoters of the mainstreaming of ESG incorporation to promote business-case or materiality ESG. Proponents of that approach correctly represent that ignoring ESG data with financial materiality is a breach of fiduciary duty. With this approach however, the investor loses agency on ESG matters and the ESG performance of an investment is an uncontrolled by-product of conventional risk and investment management decisions – there is no guarantee that the portfolio will meet ESG norms or produce ESG progress; we are back to business as usual, but with an extended dataset.

This is consistent with Milton Friedman's view of business responsibility – the mission of the corporation is to maximise shareholder value within the confines of the law. In this model, it is incumbent on lawmakers to define standards and on the administration and courts to enforce them. This position has the great merit of clarity and underlines that ESG progress will be determined by stakeholders demanding it in their engagements with corporates or imposing it via political action.

Investment is one of multiple channels of engagement and while materiality ESG is presented as The End of History for ESG incorporation, there is clear evidence that a growing number of investors hold views that are consistent with the pursuit of truly progressive ESG agendas, in the spirit of Socially Responsible Investing. This is observed even in countries that lag in their adoption of ESG incorporation. By way of illustration, a 2017 survey of U.S. individual investors by the Morgan Stanley Institute for Sustainable Investing found 23% of the population and 38% of millennials to be very interested in sustainable investing (up 4 and 10 percentage points over 2015, respectively) and a majority of respondents and 63% of millennials to be expecting a financial trade-off from investing sustainably (Morgan Stanley, 2017). Analysis of fund flows suggests that investors act on sustainability preferences – Hartzmark and Sussman (2019) find that market-wide demand for U.S. mutual funds varies as a function of their sustainability ratings in manner that is "consistent with positive affect influencing expectations of sustainable fund performance and non-pecuniary motives influencing investment decisions."

As business-case investors incorporating ESG dimensions with a view to strengthening risk management or enhancing returns join traditional values-based and socially responsible investors that wish to align their investments with personal values or social norms and to seek positive ESG impact, the motivations for incorporating ESG data into investment management have never been so diverse.

We thus think that the future of ESG incorporation is bright although we remain concerned by the risks of misleading denominations. It is telling that Responsible Investing – as defined by PRI, the largest ESG-focused organisation in the investment management industry – does not require a progressive ESG agenda or even a positive ESG impact. While PRI has demonstrated commitment to ESG progress, the amoral incorporation of ESG information into standard investment decision making is sufficient to claim the responsible investing badge. Potentially hosting ESG regressive investment strategies under the banner of responsible investing is fraught with reputational risk for the entire industry and in this regard, it is interesting to remark that "mistrust and concerns about greenwashing" is cited ahead of lack of advice, performance concerns or risk management issues as the main hindrance to the adoption of responsible investing (Eurosif, 2018). Assuming this could be corrected –– investors with progressive agendas would still need a label they could trust to identify products that go beyond compliance with laws and usage of ESG data for financial profile optimisation. The work of European lawmakers in respect of a taxonomy for environmentally sustainable economic activities is an interesting development.

How does Scientific Beta position itself in respect of ESG incorporation?

Over the last ten years, our researchers have assisted a wide variety of investors with the incorporation of ESG dimensions into their passive investments. Given our academic origins, this has been done in a manner that respects our investment tenets and the extant academic evidence on the financial relevance of integrating non-financial information into portfolio construction.

The ESG incorporation philosophy of Scientific Beta centres on exclusions that are determined solely on ESG merits and demerits and applied as the first step of index construction. This approach respects the principles of ethical and socially responsible investors and, as a result, exclusions send clear signals to issuers and are straightforward to explain to stakeholders. From an ESG risk management point of view, the approach targets companies whose performance fails to meet uniform standards or lags that of their peers. Finally, from a traditional bottom line approach, the approach protects the scientifically validated sources of financial performance that smart beta and factor investing exploit. As for factor tilting, despite several decades of research into ESG investment strategies, the extant theoretical and empirical evidence cannot justify the addition of progressive ESG factors to our strategic factor menu or the augmentation of well-established factors by ESG signals. Likewise for scientific diversification weighting, the literature on improving risk parameter estimation with ESG data, while more promising, is still very much in its infancy.

This is in stark contrast with integrated ESG approaches that allow for compensation between ESG and financial characteristics at the security level and/or approach ESG performance as a portfolio average and allow a higher allocation to ESG leaders to make up for a higher allocation to ESG laggards. Exclusions based on composites of ESG and financial performance convey mixed signals to issuers in respect of the importance of integrating ESG considerations and may be challenging to explain to stakeholders. Approaches driven by average ESG scores at the portfolio-level assume that the utility of ESG performance is linear when casual observation and academic studies indicate that poor ESG performance matters more to consumers than strong ESG performance. For the average investor with progressive ESG motivations, it is unlikely that the non-financial impact of holding a company facing a critical controversy could be neutralised by an investment of the same amount in a company that has earned a corporate sustainability award; and for investors following a deontological approach, the suggestion is obscene. Even for a business-as-usual investor, the mere assumption of controversy risk aversion invalidates the possibility of a linear relationship between ESG performance and its utility. Approaches driven by portfolio-level averages also assume that the risks that ESG scores may proxy are linear; while this may be convenient, this is not a conservative approach to take for downside risk management in the absence of theoretical or empirical justifications. In traditional financial terms, approaches based on composites of ESG metrics and traditional financial signals lack theoretical support and may dilute control over the assumption of rewarded risk factors and hamper diversification or control of unrewarded or unwanted risks.

It is important to underline that while we do not represent that ESG incorporation improves the risk/return profile of our indices, we also observe that their improved ESG profiles are achieved with no financial penalty as the ESG and Low Carbon Fiduciary Option versions of our indices achieve back-tested performance that is in line with that of standard versions. Market inefficiencies are naturally possible and could translate in additional risk-adjusted relative performance for the ESG and Low Carbon Fiduciary Option indices if over the holding period, the market realised that excluded/retained securities were over/under-priced for idiosyncratic or systematic reasons.

References:

Eurosif, 2018. EUROPEAN SRI STUDY 2018. EUROSIF A.I.S.B.L. European Sustainable Investment Forum, Brussels, available at: http://www.eurosif.org/wp-content/uploads/2018/11/European-SRI-2018-Study-LR.pdf.
Friedman, M., 1970. The Social Responsibility of Business is to Increase its Profits, The New York Times Magazine, September 13.
Hartzmark, S. M. and A. B. Sussman, 2019. Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows. European Corporate Governance Institute (ECGI) - Finance Working Paper No. 565/2018, available at: https://ssrn.com/abstract=3016092.
Morgan Stanley, 2017. Sustainable Signals – New Data From the Individual Investor (Executive Summary), Morgan Stanley Institute for Sustainable Investing, White Paper, available at: https://www.morganstanley.com/pub/content/dam/msdotcom/ideas/sustainable-signals/pdf/Sustainable_Signals_Whitepaper.pdf.

Frédéric Ducoulombier, ESG Director, Scientific Beta: Frédéric Ducoulombier is ESG Director at Scientific Beta. From 2015 to 2019, he was in charge of risk and compliance for Scientific Beta having previously served EDHEC Business School's risk and investment management research centre for ten years as the founding director of EDHEC Risk Institute's executive education arm and of EDHEC Risk Institute–Asia. At EDHEC Business School, he also taught economics and finance, managed graduate programmes and served as Deputy Associate Dean of Graduate Studies and Deputy Associate Dean of Research and Development. His research and advocacy work has focused on the purported risks of exchange traded funds, the governance and transparency of financial indices, non-financial risks in the fund management industry, smart beta and factor investing and the integration of environmental, social and governance criteria into investment. He was a member of the Consultative Working Group of the European Securities Markets Authority's Financial Innovation Standing Committee from February 2015 to January 2017. He holds a master's in management from IESEG School of Management, a graduate certificate in East Asian Studies from a University of Montréal/McGill University program, and is a Chartered Alternative Investment Analyst® designee.

Scientific Beta has forged partnerships with asset managers who not only replicate its indices but also propose open funds enabling investors to readily invest in the strategies proposed by Scientific Beta that they have selected. In this issue, we focus on CoreShares and Global X.

CoreShares

CoreShares, a leading passive investment manager in South Africa with a particular focus on smart beta, released an evidence based investing documentary in May 2019 entitled, "Hard Questions. Better Answers", featuring a number of global thought leaders on a range of topics, including the participation of Eric Shirbini, Global Research and Investment Solutions Director at Scientific Beta, speaking on the subject of factor investing (at 17'44 in the corresponding video).

In October, 2017, CoreShares launched the CoreShares Scientific Beta Multi-Factor Index Fund (share code: SMART) based on the SciBeta CoreShares South-Africa Multi-Beta Multi-Strategy Six-Factor EW index. The fund's aim is to capture academically-proven investment styles in the market within one holistic index approach. The solution is suitable for investors looking to incorporate a low cost, rules-based, smart beta equity solution into their investment framework with an additional level of diversification by combining multiple factors and therefore smoothing the cyclicality that is associated with individual factors. The key advantages of this smart multi-factor approach are its diversification, not only of factor risk but also of specific risk, and its top-down approach to risk allocation, thus meeting investors' concern to keep risk management at the forefront of their investments. The Scientific Beta Multi-Beta Multi-Strategy Six-Factor EW Indices correspond to an equal-weighted combination of the most popular choices of factor considered to be well-rewarded in the financial literature (Value, Size, Momentum, Low Volatility, High Profitability and Low Investment). These indices benefit from a double diversification – allocation across different factors (multi-beta allocation) along with diversification of the specific risks of each smart factor index (diversified multi-strategy weighting scheme).

As of 10 July, 2019, the CoreShares Equally Weighted Top 40 ETF, listed on the Johannesburg stock exchange, was converted to tracking the CoreShares Scientific Beta Multi-Factor Index Fund.

Hard Questions. Better Answers, CoreShares documentary, May 2019

Global X

In May, 2019, the multi-factor Scientific Beta suite offered by Global X, a New York-based sponsor of exchange-traded funds founded in 2008, celebrated its 4-year anniversary of listing on the New York Stock Exchange for the following ETFs based on Scientific Beta multi-factor indices:

Global X: Celebrating 4 Years - Scientific Beta • The Global X Scientific Beta US ETF (Bloomberg ticker: SCIU) which replicates the Scientific Beta United States Multi-Beta Multi-Strategy Four-Factor ERC Index (Bloomberg ticker: SBUXRHMG)

• The Global X Scientific Beta Japan ETF (Bloomberg ticker: SCIJ) which replicates the Scientific Beta Japan Multi-Beta Multi-Strategy Four-Factor ERC Index (Bloomberg ticker: SBJURHMN)

• The Global X Scientific Beta Europe ETF (Bloomberg ticker: SCID) which replicates the Scientific Beta Extended Developed Europe Multi-Beta Multi-Strategy Four-Factor ERC Index (Bloomberg ticker: SBRXRHMN)

• The Global X Scientific Beta Asia ex-Japan ETF (Bloomberg ticker: SCIX) which replicates the Scientific Beta Developed Asia-Pacific ex-Japan Multi-Beta Multi-Strategy Four-Factor ERC Index (Bloomberg ticker: SBAXRHMN)

The Scientific Beta Multi-Beta Multi Strategy Four-Factor ERC Indices are characterised by the equalisation of the contribution to the tracking error (ERC) of each smart factor among the most popular choices of factor considered to be well-rewarded in the financial literature (Value, Size, Momentum and Low Volatility). These indices benefit from a double diversification – allocation across different factors (multi-beta allocation) along with diversification of the specific risks of each smart factor index (diversified multi-strategy weighting scheme).

Scientific Beta Multi Smart Factor Indices Performance

Many investors choose to diversify their factor exposure so as not to be exposed to variations in the performance of a single factor. For this reason, Scientific Beta Multi-Beta Multi-Strategy (MBMS) indices provide an allocation to well-rewarded smart factor indices. Scientific Beta proposes a wide range of Multi-Beta Multi-Strategy indices based on the same Smart Beta 2.0 investment philosophy. This section presents those indices that enable the diversification of factor and specific risks to be reconciled. Among these indices, we have chosen to present some of the more popular ones, namely the strategy with the longest live track record – the Scientific Beta Multi-Beta Multi-Strategy Four-Factor Equal-Weight index and a strategy created more recently which takes into account the interactions between single-factor indices in order to provide higher factor intensity at a multi-factor level – represented by the Scientific Beta High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy Equal-Weight index and its Sector Neutral and combined Sector Neutral/Market Beta Adjusted (Overlay) versions.

Performance Overview

The table below displays an overview of the relative and absolute performance of Scientific Beta Multi-Beta Multi-Strategy indices for the Developed, United States and Global regions over different time periods.

Region	Multi-Beta Multi-Strategy Index	Nº Constituents	Relative Return Compared to Cap-Weighted			Information Ratio	Absolute Return		Volatility	Sharpe Ratio
Region	Multi-Beta Multi-Strategy Index	Nº Constituents	Past Quarter	YTD	10 Years	10 Years	Past Quarter	10 Years	10 Years	10 Years
Developed	4-Factor EW	1726	-0.76%	-1.50%	1.14%	0.52	3.53%	12.28%	12.13%	0.97
	HFI 6-Factor 4-Strategy EW	1172	-0.96%	-2.01%	2.20%	0.83	3.33%	13.35%	11.62%	1.11
	HFI 6-Factor 4-Strategy EW Sector Neutral	1191	-0.90%	-1.53%	1.92%	0.89	3.39%	13.07%	12.00%	1.05
	HFI 6-Factor 4-Strategy EW Sector Neutral Market Beta Adjusted (Overlay)	1191	-0.66%	-0.08%	3.23%	1.88	3.63%	14.37%	13.47%	1.03
SciBeta Developed CW		1852					4.29%	11.15%	13.18%	0.81
United States	4-Factor EW	468	-0.11%	-0.40%	0.43%	0.15	4.41%	15.00%	14.10%	1.03
	HFI 6-Factor 4-Strategy EW	316	-0.55%	-1.40%	1.20%	0.36	3.98%	15.77%	13.45%	1.14
	HFI 6-Factor 4-Strategy EW Sector Neutral	318	-0.61%	-0.86%	1.16%	0.45	3.91%	15.74%	14.15%	1.08
	HFI 6-Factor 4-Strategy EW Sector Neutral Market Beta Adjusted (Overlay)	318	-0.35%	0.97%	2.60%	1.06	4.18%	17.18%	15.53%	1.07
SciBeta United States CW		500					4.52%	14.57%	14.92%	0.94
Global	4-Factor EW	2366	-0.76%	-1.73%	1.21%	0.56	3.18%	11.85%	11.81%	0.96
	HFI 6-Factor 4-Strategy EW	1608	-0.93%	-2.16%	2.33%	0.89	3.00%	12.97%	11.35%	1.10
	HFI 6-Factor 4-Strategy EW Sector Neutral	1629	-0.96%	-1.73%	2.07%	0.97	2.98%	12.71%	11.72%	1.04
	HFI 6-Factor 4-Strategy EW Sector Neutral Market Beta Adjusted (Overlay)	1629	-0.74%	-0.31%	3.35%	2.07	3.20%	13.99%	13.24%	1.02
SciBeta Global CW		2545					3.94%	10.64%	13.00%	0.78

Based on daily total returns in USD as of 30/06/2019. The base date is 21/06/2002 for Scientific Beta Multi-Beta Multi-Strategy 4-Factor EW indices, Scientific Beta High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy EW indices and Scientific Beta High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW indices, 18/06/2004 for Scientific Beta High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW Market Beta Adjusted (Overlay) indices and 19/12/2003 for Scientific Beta Multi-Beta Multi-Strategy CW indices. All statistics are annualised, except for the past quarter relative returns and year-to-date relative returns which are non-annualised. Performance ratios that involve the average returns are based on the geometric average, which reliably reflects multiple holding period returns for investors. The risk-free rates used are defined according to the regional universe of the index. The number of index constituents are as of the last quarterly rebalancing, i.e. 21/06/2019.

During the second quarter of 2019, absolute returns for the above indices varied from 2.98% for the SciBeta Global High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW index to 4.41% for the SciBeta United States Multi-Beta Multi-Strategy Four-Factor EW index, while relative returns ranged from -0.96 % for the SciBeta Developed High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy EW index and the SciBeta Global High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW index to -0.11% for the SciBeta United States Multi-Beta Multi-Strategy Four-Factor EW index .

In order to limit the performance conditionality of multi-factor strategies, Scientific Beta proposes to adjust the market beta of these strategies. The market beta of the index can be adjusted via a market risk control option based on a cap-weighted overlay component, which is updated quarterly to align the multi-factor index market beta with the beta of the market. This market beta adjustment (MBA) has of course positive consequences on the long-term performance of the proposed strategy as the latter benefits fully from the equity premium but also on the short-term performances as it ensures relative performances are positive in bull markets. The market beta adjusted (MBA) index, which has a market risk aligned with the market risk of the cap-weighted reference, does not suffer from the same bull/bear conditionality as the standard index (without the MBA): the MBA index tends to perform well over the same periods as the cap-weighted reference. In addition, since there is no orthogonality between factors and sectors in long-only investment, factor choice strategies can lead to sector biases compared to the cap-weighted benchmark. These biases can impact positively or negatively the relative performance of multi-factor strategies. This underexposure can be reduced with a sector risk control option. The combination of the Sector Neutral and MBA risk control options allows to manage both sector and market risks. For example, year-to-date, the SciBeta United States High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW Market Beta Adjusted (Overlay) index displayed relative performance of 0.97%, while the SciBeta United States High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy EW index underperformed the cap-weighted reference at -1.40%. These risk control options are of course fiduciary choices at the discretion of the investor, since the Scientific Beta indices without the MBA and/or Sector Neutrality options exhibit very good risk-adjusted performances over the long-term by favoring a reduction of volatility risk and a defensive bias.

Over the past ten years, the SciBeta Developed Multi-Beta Multi-Strategy Four-Factor EW index, the SciBeta Developed High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy EW index, the SciBeta Developed High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW index and the SciBeta Developed High-Factor-Intensity Diversified Multi-Beta Multi-Strategy (Sector Neutral) 6-Factor 4-Strategy EW Market Beta Adjusted (Overlay) index posted strong annual relative returns of 1.14%, 2.20%, 1.92% and 3.23% respectively, compared to cap-weighted indices.

The above performances are in line with the fiduciary choices represented by these variants of the Scientific Beta Developed Multi-Beta Multi-Strategy index. Over the long-term, the High-Factor-Intensity filter allows to benefit strongly from the rewarded risk premia and hence offers strong absolute risk-adjusted performance. As such, for example, the Developed High-Factor-Intensity Diversified Multi-Beta Multi-Strategy 6-Factor 4-Strategy EW index has a high Sharpe ratio of 1.11, representing an improvement of 37.0% compared to the cap-weighted benchmark. On the other hand, the sector neutrality and market beta adjusted risk control options, which limit the distance with the cap-weighted reference, allow an improved relative risk-adjusted performance to be obtained, with Information ratios of respectively 0.89 for the sector neutral version of the index and 1.88 in the case of the combined sector neutral and market beta adjustment risk control options.

De facto, for the same performance engine represented by the exposures to the same six factors and the same diversification scheme of specific risks which increases the risk-adjusted performance associated with each factor, the investor, depending on their fiduciary choices, obtains different pay-offs for their factor strategy that are in line with the risk objectives.

The relative and absolute performance data for Scientific Beta regional universes is available here.

Live Performance

The table below reports the live performance of the Scientific Beta Multi-Beta Multi-Strategy indices for the Developed ex-USA and United States regions as of 30 June, 2019.

Region	Multi-Beta Multi-Strategy Index	Nº Constituents	Annualised Relative Return Compared to Cap-Weighted	Annualised Absolute Return	Volatility	Sharpe Ratio
Region	Multi-Beta Multi-Strategy Index	Nº Constituents	From 20/12/2013 to 30/06/2019
Developed ex-USA	4-Factor EW	1251	1.40%	5.39%	10.89%	0.42
	HFI 6-Factor 4-Strategy EW	852	2.60%	6.60%	10.90%	0.53
	HFI 6-Factor 4-Strategy EW Sector Neutral	867	2.63%	6.63%	10.86%	0.54
	HFI 6-Factor 4-Strategy EW Sector Neutral Market Beta Adjusted (Overlay)	867	3.02%	7.02%	12.03%	0.52
United States	4-Factor EW	467	-0.56%	10.77%	12.02%	0.83
	HFI 6-Factor 4-Strategy EW	316	0.26%	11.58%	11.75%	0.92
	HFI 6-Factor 4-Strategy EW Sector Neutral	318	0.54%	11.86%	12.36%	0.89
	HFI 6-Factor 4-Strategy EW Sector Neutral Market Beta Adjusted (Overlay)	318	1.53%	12.85%	13.49%	0.89

Based on daily total returns in USD. The live date of the first generation Multi-Beta Multi-Strategy 4-Factor EW indices, i.e. 20/12/2013, is used as the basis as all the multi-factor indices proposed by Scientific Beta are derived from the same strategy. Although the other indices were created more recently, the longest live period is used for comparison purposes. The statistics are annualised and performance ratios that involve the average returns are based on the geometric average, which reliably reflects multiple holding period returns for investors. The risk-free rates used are defined according to the regional universe of the index.

Over their live period, all but one of the above Scientific Beta Multi-Beta Multi-Strategy indices posted positive relative returns compared to the cap-weighted benchmark.

The live performance data for Scientific Beta regional universes is available here.

Quarterly Smart Beta Performance Report, June 2019

White Papers

In a concern for transparency, and as part of its aim to help investors to understand and to invest in smart beta equity strategies, Scientific Beta has published a large number of white papers that are freely available on the Scientific Beta platform.

Highlighted White Papers

Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the Smart Beta Space
June 2019

Although gaining explicit exposure to priced risk factors is expected to provide good long-term risk-adjusted performance, investing in these very factors also exposes investors to a number of hidden or implicit risks that could be important drivers of short-term performance. To reconcile such risk exposures with investors' preferences, it is crucial that they be well documented. With cap-weighted indices, which represent the default option in terms of a passive investment reference, being increasingly called into question, smart beta’s main fiduciary message is that there is no best solution in general, but rather a best solution that allows the investor’s fiduciary choices to be executed in the most efficient way. Ultimately, the choice on managing these risks is a key fiduciary decision that cannot be left to the discretion of an index provider that has no status to do so. Asset owners should also start improving governance practices by starting a risk conversation on smart beta investments with stakeholders.

Investability of Scientific Beta Indices
June 2019

With the advent of smart beta equity indices, which represent alternatives to market-cap weighted indices, a major question on their investability has also been raised: at what cost will investors be able to trade the index constituents in the same proportions as the underlying strategy? This paper describes how Scientific Beta ensures the investability of its indices through the different aspects of the Scientific Beta approach to implementation management and cost control, and explains how the adjustments have specific impacts on key implementation metrics such as turnover, capacity and liquidity of various strategies. It also uses the recent advances in market microstructure research to estimate the transaction costs of Scientific Beta's smart beta indices. The turnover and liquidity profile of single-factor and multi-factor indices are discussed in detail.

Other White Papers

Supplements in Partnership with Industry Publications

EDHEC has established partnerships with a number of industry publications to produce special editorial supplements providing industry-relevant research of the highest academic standards.

P&I Research for Institutional Money Management
April 2019

The latest issue of the Research for Institutional Money Management supplement to P&I contains three contributions from Scientific Beta. Articles examine the use of academically grounded factors in investment practice, present the framework behind Scientific Beta's defensive offering and look at the importance of consistency in index methodology.

Using Academically-Grounded Factors in Investment Practices
In the first article, we look at the use of academically grounded factors in investment practice. We observe that the factor finding process often maximizes the risk of finding false factors, so most factors used in commercially available tools and products are likely to be false. We conclude that the use of non-standard factors can lead to unintended exposures and misunderstandings concerning the risk exposures.

A Defensive Offering that is Robust over the Long Term
A second article presents Scientific Beta's defensive offering which relies on three different indexes to satisfy investors' various objectives and constraints. In line with the defensive objective, they deliver good levels of volatility reduction and capital protection in bear markets relative to the cap-weighted index.

What are the Risks of Making Changes to Indexes?
Lastly, we examine changes that are made to indexes. Methodologies of factor-based equity indexes undergo frequent changes, leading to inconsistencies over time. Inconsistencies in index methodology make it difficult for investors to evaluate index offerings and may expose them to a risk of relying on spurious performance records.

Scientific Beta Unveils Complimentary State-of-the-Art ESG and Climate Risk Reporting

Scientific Beta is pleased to announce the release on the Scientific Beta platform of enhanced Environmental, Social and Governance (ESG) and climate risk reporting that aims to assist investors in meeting the challenges and seizing the opportunities of incorporating ESG dimensions into passive investment management.

Commenting on the new reporting suite, Professor Noël Amenc, CEO of Scientific Beta, said, "Scientific Beta is proud to be presenting cutting-edge ESG and climate risk reporting that is available for all of Scientific Beta's indices, including our ESG and Low Carbon indices. Climate risk reporting is particularly important in the factor investing space, because factor strategies often have larger carbon footprints than cap-weighted indices."

Scientific Beta's enhanced ESG reporting includes over a dozen reports covering ESG Norms and climate change. Offered on a complimentary basis and available not only for ESG indices but across the entire index offering, it provides unparalleled pre-selection and ongoing transparency on index exposure to ESG issues at the top of institutional investor concerns. As such, it facilitates the incorporation of ESG dimensions in investment analysis and decision-making as well as performance measurement and reporting.

Scientific Beta recognises the diversity of investor motivations justifying the incorporation of ESG dimensions into investment selection and management and its enhanced ESG reporting is designed to serve the needs of ethical and socially responsible investors as well as those of business-case ESG investors.

Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of ESG Norms and Climate Change Issues in Investment Management, Scientific Beta white paper, July 2019

French Insurance Sector Pension Fund Announces Investment in Scientific Beta Low Carbon Multi-Factor Indices

Scientific Beta, the smart beta index provider, and SACRA, a pension fund for the French insurance sector, have announced the launch of two low carbon multi-factor indices for the US and Eurozone regions.

This move comes as part of SACRA's reorganisation of the management of its equity portfolio. The US equity portfolio, and part of the Eurozone equity allocation, are now invested to track the two multi-factor indices from Scientific Beta. In addition to seeking higher long-term financial returns by efficiently harvesting academically grounded risk premia, these indices comply with SACRA's own responsible investment policy and apply a low carbon filter enabling a significant reduction in the strategies' carbon intensities.

In an original set-up, the rest of SACRA's Eurozone equity portfolio remains managed by four traditional stock-picking asset managers, but these are benchmarked against the Scientific Beta SACRA indices, both in terms of financial performance and carbon intensity reduction. This means the expectations placed on SACRA's other asset managers are much more demanding, both in terms of financial value added and climate change mitigation, than when standard cap-weighted benchmarks are used.

Commenting on this launch, Professor Noël Amenc, CEO of Scientific Beta, said, "We are delighted to be providing SACRA with these low carbon multi-factor indices. Reconciling low carbon and multi-factor investing is the fruit of an R&D process that our researchers in both Singapore and Nice have been conducting for many years and it is one of the top priorities for Scientific Beta, because the fight against climate change is one of our main corporate missions."

Stève Baumann, Chairman of the Board of SACRA, added, "Our aim with these indices is to benefit from risk premia that are grounded in academia while reducing carbon intensity as part of our responsible investment policy. It was also important for us to be able to benchmark our asset managers against the Scientific Beta SACRA low carbon multi-factor indices, so we are very pleased to be doing so."

EDHEC Scientific Beta Days 2019 European and North American Conferences

EDHEC Scientific Beta Days Europe – 10-11 October, 2019 – The Barbizon Palace, Amsterdam, Netherlands
EDHEC Scientific Beta Days North America – 24-25 October, 2019 – The Ritz Carlton, Boston, United States

These annual two-day conferences, organised by Scientific Beta in Europe and North America, will present the asset owner and financial advisory communities with the latest conceptual advances and research results in smart beta investing, enabling their implications and applications to be discussed with researchers who combine expertise of advanced financial techniques with a sound awareness of their industry relevance. The events will include multiple plenary sessions, workshops and practical sessions allowing professionals to review major industry challenges, explore state-of-the-art investment techniques and benchmark practices to advances in research.

This year, the conferences will focus on the following themes:

Can factor risk premiums disappear with their success?
Is there an ESG factor?
How to reconcile ESG and factor investing
Limiting the carbon impact of factor strategies
How to manage the risks of factor-based investment
Protecting equity investment against drawdown risk: the case for maximum drawdown and maximum loss risk-control options
Modifying the factor exposures of an existing portfolio: factor completeness portfolio and single-factor allocation
What factor allocation to reduce the dependence of the performance of multi-factor strategies on economic regimes? From factor balance to regime premia diversification
How to assess the robustness of a factor strategy
Are some defensive strategies more efficient than others?
How to measure the investability of a multi-factor strategy
Building a multi-factor long-short strategy

The conferences will include the participation of a wide panel of industry experts, as listed below, providing participants with insights into the practical applications of the research presented and opportunities for more in-depth discussion:

Scientific Beta Days Europe:

Ingrid Albinsson, Head of Strategy, CIO, AP7; Guillaume Arnaud, Head of Quantitative Investment Strategies, Société Générale; Barbara Bleijenbergh, Senior Strategist, PME; Marc-Gregor Czaja, Global Head of Equities and Derivatives, Allianz; Aniket Das, Investment Strategist - Index & Smart Beta Solutions Group, LGIM; Camiel Jeurissen, Investment Manager, DSM Pension Services; Arnaud Jobert, Managing Director, Global Head Equities Investable Indices, JPMorgan; Yong Lin, Portfolio Manager, Achmea Investment Management; Alexander Neszvecsko, Portfolio Manager, European Patent Office; Mark Pemberton, Executive Director, Morgan Stanley; Bernhard Scherer, Head of Portfolio Management & Head of Product Development, Bankhause Lampe; Luca Simoncelli, Senior Portfolio Manager, Fideuram; Laurent Trottier, ‎Global Head of ETF, Indexing & Smart Beta Management, Amundi.

Scientific Beta Days North America:

Greg Behar, Head of Index Investment Strategy, LGIMA; Stephen Beinhacker, Global Head of Equity, SEI Investments Company; Paul Bouchey, Chief Investment Officer, Parametric Portfolio Associates; Nelson Da Conceicao, ‎Portfolio Manager - Global Equities, California Public Employees Retirement Systems (CALPERS); Mike Clark, Head of Equity Derivatives Trading, Société Générale; Anny-Claude Duval, Senior Director, External Portfolio Management, Caisse de Dépôt et Placement du Quebec (CDPQ); Alex Farquhar, ‎Consultant & Director of Traditional Research, Ellwood Associates; François Gagnon, Managing Director of Investments, University of Michigan Investment Office; Michael W. Griswold, Senior Director, Risk Management and Asset Allocation, Ascension Health; Syed Haque, Director of Public Markets, United Parcel Service; Arnaud Jobert, Managing Director, Global Head Equities Investable Indices, JP Morgan; John Pirone, Senior Vice President, Capital Markets Research Group, Callan Associates Inc; Emiliano Rabinovich, Senior Portfolio Manager, State Street Global Advisors; Nicolas Richard, Executive Vice President, Investments and Chief Operating Officer, Desjardins Global Asset Management; Dan Scholz, Director Investment Strategies, Nisa Investment Advisors; Alec Stais, Chief Investment Officer, State of Rhode Island Office of the General Treasurer; Corrado Tiralongo, Chief Investment Officer, Counsel Portfolio Services; Gareth Witten, Director, Portfolio Strategy & Investment Risk, Ontario Power Generation.

Further details are available in the respective programmes:

EDHEC Scientific Beta Days Europe 2019 programme

EDHEC Scientific Beta Days North America 2019 program

• Programme • Program
• Register • Register

The conferences are reserved for asset owners (including pension schemes, charities, endowments, foundations, insurance companies, single family offices and financial executives from non-financial companies) and institutional consultants. Admission is complimentary and by invitation only.

For further information about these events, please contact Joanne Finlay at scientificbetadays@scientificbeta.com.

Can SA’s smart beta funds get smarter?

Business Day (09/07/2019)

"(...) This week, CoreShares will convert its Equally Weighted Top 40 ETF into the Scientific Beta Multi-Factor Index Fund. (...) The new fund will track a multifactor index constructed by an indexation business attached to leading French business school EDHEC, says Chris Rule, head of product at CoreShares. The EDHEC Risk Institute’s multifactor index includes exposure to six factors: value, momentum, small cap, low volatility and two measures of quality — high profitability and low investment. (...)"
Copyright tiso blackstar group

Alaska Retirement axes 19 managers running $2.4 billion

Pensions & Investments (03/07/2019)

"(...) The terminations were the result of the staff's review of the board's overall $5.8 billion domestic equity allocation. According to meeting materials, the recommendation is the result of the staff believing "prospective performance can be improved and the manager structure simplified by collapsing the existing set of internally managed and externally managed strategies into the following internally managed mandates: S&P 900, S&P 600, Scientific Beta U.S. MBMS 4-Factor EW and the domestic equity pilot portfolio." (...)"
Copyright Crain Communications Inc.

Methods for managing volatility in indices and ETPs revealed

ETF Stream (06/06/2019)

"(...) While risk parity and equal risk contribution share the same basic objective of equal risk weighting, risk parity weights assets inversely to their volatility whereas the equal risk contribution method takes the covariance between assets into account to reduce overall portfolio risk through diversification. It requires a portfolio optimization tool to arrive at the solution. Several index providers have introduced index families around this concept including (...) Scientific Beta (EDHEC) and ETF launches include the Global X Scientific Beta US ETF which has reached $100 million in assets. (...)"
Copyright ETF Stream

Drilling down on ESG and factors with Scientific Beta

ETF Stream (28/05/2019)

Interview with Frédéric Ducoulombier, Director of Risk and Compliance, Scientific Beta

"(...) The news at the start of May that Scientific Beta had launched two new multi-factor indices in order to satisfy the demands of a French pension fund, SACRA, with regard to integrating ESG funds threw the spotlight on how ESG mixes and matches up with factor investing. ETF Stream caught up with Frederic Ducoulombier, director of risk and compliance for ERI at Scientific Beta, to run through some of the issues raised by marrying factor investing with low carbon aim and got around to the question of whether ESG is a factor in and of itself (spoiler alert – certainly not). (...)"
Copyright ETF Stream

French SACRA announces investment in low carbon multi-factor indices

European Pensions (10/05/2019)

"(...) SACRA, a pension fund for the French insurance sector, and Scientific Beta have announced the launch of two low carbon multi-factor indices for the US and Eurozone regions. (...) Commenting on the move, SACRA board chairman Steve Baumann said: "Our aim with these indices is to benefit from risk premia that are grounded in academia while reducing carbon intensity as part of our responsible investment policy. It was also important for us to be able to benchmark our asset managers against the Scientific Beta SACRA low carbon multi-factor indices, so we are very pleased to be doing so." (...)"
Copyright Perspective Publishing Limited

On the same subject:
• Scientific Beta and SACRA launch US and Eurozone low carbon multi-factor indices, Institutional Asset Manager, 08/05/2019
• French insurance sector pension fund announces investment in Scientific Beta low carbon multi-factor indices, Pension Policy International, 08/05/2019
• Scientific Beta’s pension fund-friendly low carbon/multi-factor indices, ETF Stream, 07/05/2019

ETF Insight: The dangers of smart beta backtesting

ETF Stream (07/05/2019)

"(...) At the heart of the problem is the ability of researchers to wield ever greater computing power in search of factors which 'work' in a given dataset. But as Felix Goltz, research director at Scientific Beta, says, these factors will have no relevance outside the original dataset due to selection biases. Hence the backtest performance can evaporate once the factor goes live. "Product providers explicitly acknowledge that the guiding principle behind factor definitions is to analyse a large number of possible combinations in short data sets and then retain the factors that deliver the highest backtest performance," he says. (...)"
Copyright ETF Stream

As part of its international development programme and in order to strengthen its index development activity, the EDHEC group, one of Europe's leading research and teaching institutions, is recruiting for positions within Scientific Beta in Boston, London and Nice. To apply, please send your CV and a cover letter to recruitment@scientificbeta.com.

Salaries are determined according to the EDHEC pay scale, based on qualifications and prior experience.
Written and spoken English is essential, and basic spoken French is a plus.
An EU work permit is mandatory for the positions in Scientific Beta's Nice and London offices and a US work permit is mandatory for the position in Boston.

For more information about Scientific Beta, please visit our website and our corporate YouTube channel.

Investment Solutions and Product Specialist (London or Boston)

The successful candidate will be responsible for providing support to clients and users on conceptual frameworks, features and calculations for single and multi-factor indices. This will require liaising with technical and research teams to meet client demands and responding to highly analytical/quantitative inquiries. The role also involves supporting the Business Development Manager on sales activities with expert presentations to clients and providing advice on the implementation of multi-factor solutions for clients on the basis of the wide range of indices designed by Scientific Beta in coordination with the research teams.

The successful candidate should have a quantitative educational background (statistics, mathematics, finance). A PhD would be a plus. Prior client-facing experience within a financial institution, preferably in portfolio management, is necessary, together with financial markets skills, extensive knowledge of asset pricing and multi-factor products. The candidate should also be able to communicate complex quantitative academic literature to audiences of asset owners and to work independently in a small team, showing initiative to support clients and prospects with the goal of winning business together with the Business Development Managers.

This is a global position that is based in London or Boston but requires frequent travel to Europe and North America.

Junior Investment Solutions and Product Specialist (London)

Under the supervision of the Global Research and Investment Solutions Director, the successful candidate will be providing support to clients and users on conceptual frameworks, features and calculations for single and multi-factor indices. This will require liaising with technical and research teams to meet client demands and responding to highly analytical/quantitative inquiries. The role also involves supporting the Business Development Manager on sales activities with expert presentations to clients and providing advice on the implementation of multi-factor solutions for clients on the basis of the wide range of indices designed by Scientific Beta in coordination with the research teams.

The successful candidate should have a quantitative investment educational background (a Master's degree is mandatory). A first experience within a financial institution, preferably in portfolio management, is required together with financial markets skills, extensive knowledge of asset pricing and multi-factor products. The candidate should also be able to communicate complex quantitative academic literature to audiences of asset owners and to work independently in a small team, showing initiative to support clients and prospects with the goal of winning business together with the Business Development Managers.

This position is based in London, but requires frequent travel to Europe and North America.

Quantitative Equity Analyst (London and Nice)

The successful candidate will work in Scientific Beta's Index Department and will contribute to the development and design of the index offering and custom solutions. The candidate will be involved in the improvement of the design of Scientific Beta's current index offering; R&D on new indices, risk control options and/or custom solutions and new analytics; drawing up white papers, presentations and internal documents associated with the index offering; custom solutions, analytics and ongoing R&D.

The position requires a Master's degree or PhD in Finance, Financial Engineering or a related discipline from a leading institution and several years' of experience obtained within an asset management firm, index provider or investment bank.

The successful candidate will have thorough knowledge of equity factor investing both from a theoretical and practical perspective. Independent, open-minded and resourceful, they will have advanced knowledge of financial statistics, as well as programming aptitude in MATLAB (or an equivalent language), together with skills to write and deliver top quality documents, such as presentations or white papers, at short notice.

Two positions are available, one in London and one in Nice.

Quantitative Analyst (London or Nice)

The successful candidate will be a quantitative analyst with initial experience in quantitative equity portfolio construction and equity factor investing implementation if possible. The position requires a Master's degree in Finance or Financial Engineering from a leading institution and experience in constructing quantitative equity portfolios within an equity index provider, investment bank or asset manager.

The candidate will support the Client Services team in analysing and coordinating clients' requests (index simulation, index performance analysis, client reports).

Experience in drafting and publishing equity analysis reports for a broad audience in English is a must (excellent writing skills are crucial). The position also requires a strong analytical mind.

The candidate further needs to have a sound command of Matlab for financial computations, in particular in the area of portfolio construction and performance analysis.

Flexibility, responsiveness and team spirit are essential.

MatLab Developer – Production Team (Nice)

The successful candidate will be an Experienced MatLab Developer with skills in quantitative finance (calculation and back testing). A typical profile would be an engineering graduate from a leading school, with subsequent experience in software development, and a qualification or knowledge in a quantitative discipline of finance. Experience in a software development role in a financial company would be a strong asset for the position.

Under the supervision of the Production Director, the successful candidate will be in charge of the improvement and documentation of the back-end tier of Scientific Beta's software solution, which produces the thousands of indices that are representative of its Smart Beta 2.0 approach. The candidate will intervene on the various layers involved in the platform, from financial data processing to index valuation and analytics. The position's scope includes the prototyping of methodological evolutions and custom indices and their corresponding documentation and reporting.

The candidate will be experienced in safe development principles and techniques. They will master development in MatLab, with continuous integration and testing, while supporting software reuse and refactoring. Knowledge of operating systems and scripts (Windows and Linux) would be an asset.

The position requires someone who is proactive and passionate about ensuring the quality of software deliverables, and who can communicate with the Client Services, Operations and Research teams.

Scientific Beta

Scientific Beta aims to be the first provider of a smart beta indices platform to help investors understand and invest in advanced beta equity strategies.

Established by EDHEC-Risk Institute, one of the very top academic institutions in the field of fundamental and applied research for the investment industry, Scientific Beta shares the same concern for scientific rigour and veracity, which it applies to all the services that it offers investors and asset managers.

The Scientific Beta offering covers three major services:

Scientific Beta Indices are smart beta indices that aim to be the reference for the investment and analysis of alternative beta strategies. Scientific Beta Indices reflect the state-of-the-art in the construction of different alternative beta strategies and allow for a flexible choice among a wide range of options at each stage of their construction process. This choice enables users of the platform to construct their own benchmark, thus controlling the risks of investing in this new type of beta (Smart Beta 2.0).

Within the framework of Smart Beta 2.0 offerings, Scientific Beta provides access to smart factor indices, which give exposure to risk factors that are well rewarded over the long term while at the same time diversifying away unrewarded specific risks. By combining these smart factor indices, one can design very high performance passive investment solutions.
Scientific Beta Analytics are detailed analytics and exhaustive information on its smart beta indices to allow investors to evaluate the advanced beta strategies in terms of risk and performance. The analytics capabilities include risk and performance assessments, factor and sector attribution, and relative risk assessment. Scientific Beta Analytics also allow the liquidity, turnover and diversification quality of the indices offered to be analysed. In the same way, analytics provide an evaluation of the probability of out-of-sample outperformance of the various strategies present on the platform.
Scientific Beta Fully-Customised Benchmarks and Smart Beta Solutions is a service proposed by Scientific Beta, and its partners, in the context of an advisory relationship for the construction and implementation of benchmarks specially designed to meet the specific objectives and constraints of investors and asset managers. This service notably offers the possibility of determining specific combinations of factors, considering optimal combinations of smart beta strategies, defining a stock universe specific to the investor, and taking account of specific risk constraints during the benchmark construction process.

With a concern to provide worldwide client servicing, Scientific Beta is present in Boston, London, Nice, Singapore and Tokyo. As of December 31, 2018, there was USD 43bn in assets replicating Scientific Beta indices. 35% of these assets under replication are ESG-compliant. Scientific Beta has a dedicated team of 52 people who cover not only client support from Nice, Singapore and Boston, but also the development, production and promotion of its index offering. Scientific Beta signed the United Nations-supported Principles for Responsible Investment (PRI) on September 27, 2016.

Scientific Beta
1 George Street, #15-02, Singapore 049145
Tel. +33 493 187 851 (from 9.00am to 7.00pm CET)
E-mail: clientservices@scientificbeta.com | Website: www.scientificbeta.com

Scientific Beta Newsletter

Editorial

Climate Emergency and Investor Responsibility

Features

Scientific Beta Low Carbon Option – Supporting the Transition to a Low Carbon Economy and Protecting Multifactor Indices against Transition Risks

Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of ESG Norms and Climate Change Issues in Investment Management

The Risks of Deviating from Academically-Validated Factors

Interview

Interview with Frédéric Ducoulombier, ESG Director, Scientific Beta

Partner News

CoreShares

Global X

Performance

Scientific Beta Multi Smart Factor Indices Performance

Publications

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