As the focus on ESG continues to intensify for institutional investors, finding strategies to maximize alpha and manage risk while achieving evolving ESG goals is naturally top-of-mind. The institutional community has used factor investing to successfully target specific characteristics in stock selections for decades, so it’s no surprise that sophisticated investors are now using a factor approach to build a portfolio that maximizes ESG quality while delivering optimal returns and downside risk.
Of course, it’s no secret that there’s been a massive shift toward more sustainable investing recently. In just the past five years, for example, the global AUM in sustainable assets have more than doubled – from $1.6 trillion in 2017 to $3.3 trillion in 2021. Across the market, there’s been an associated rise in sustainable ETFs in recent years, to serve investors looking to gain easier access to ESG exposure in their portfolios. But standards and criteria for sustainability vary greatly among these products; consider that 100 sustainable ETFs were launched industry wide in Europe, Middle East, and Africa (EMEA) in the first half of 2021 alone.1
This has spurred institutional investors to call for greater transparency and reliability in sustainable ETFs, and this charge – along with the growing demand for factor-based ESG approaches that optimizes returns while controlling risk – is driving innovation to give investors more options and choice in implementing a sustainable framework. BlackRock has led this innovation by creating an ETF that answers these needs.
In November 2021, BlackRock launched ESMV, or the iShares ESG MSCI USA Min Vol Factor ETF, for this very purpose: It combines enhanced ESG selection with a second key factor that many investors already rely on to achieve higher returns while managing risk: low volatility.
The advantages of low volatility plus ESG
Institutional investors are aware of the “low-risk anomaly,” which holds that more volatile stocks tend to have lower returns, says Lukas Smart, Managing Director, Head of U.S. iShares Sustainable and Factors Product Segments at BlackRock, who cites an impactful 2006 paper as his own introduction to this important concept in factor investing earlier in his career.
“By investing in low volatility or minimum volatility strategies, investors can potentially generate market-like returns with less risk, and that’s historically what we’ve seen in our products,” says Smart. “Now, interestingly, we also see a relationship between companies that have lower volatility and better ESG attributes. For example, companies with lower volatility characteristics have shown lower carbon emissions and higher ESG scores – even if you’re not screening for ESG. And from an ESG perspective, research has shown that securities with improved ESG and climate metrics can also be more resilient. So it makes sense for investors who are concerned about risk and ESG to combine this approach, and that’s what we’ve done for them with the ESMV ETF – which is the first ETF to combine factor strategies and ESG in the US.”
ESMV takes a similar approach to reducing risk as the flagship fund USMV (launched in 2011), with the added objective of improving ESG scores and reducing carbon emissions. By selecting stocks with reduced carbon exposure and other improved ESG characteristics, “ESMV delivers best in class stocks in both min vol and ESG,” says Smart. “ESMV can help investors deliver a similar risk-return profile as the USMV, our flagship minimum volatility ETF, while also improving ESG scores by 18% to 20% and reducing carbon emissions by about two thirds,” says Smart.
As a forerunner to ESMV, BlackRock launched an ETF pairing min vol and ESG factors in EMEA in April 2020. In two years, MVEA, or the iShares MSCI USA Minimum Volatility ESG UCITS ETF, has seen its AUM grow to about $1.77 billion (as of April 2022). “MVEA has been really popular with European institutional investors because it’s helped them meet their ESG mandates and requirements, while also delivering that same differentiated exposure that min vol has provided investors for years now.”
A tale of two trends
The convergence of long-term growth in factor strategies and the recent exponential growth in sustainable investing led BlackRock to develop their new ESG minimum volatility ETF in the US, says Smart: “In a little more than 10 years, the factor ETF industry has grown from about $50 billion in 2010 to about $650 billion at the end of 2021, with iShares factor ETF platform reaching around $180 billion,” he explains. “Then we’ve seen exponential growth of sustainable investing more recently, with global sustainable assets topping three trillion dollars at the end of 2021 – almost double what it was in just 2019.”
The intersection of these two trends made it much easier to construct an ESG min vol index, says Smart. “The key tenets that have always informed what we’ve done here at BlackRock have been access and innovation, and combining those tenets with these simultaneous growths in factor approaches and sustainable investing led us to create ESMV.”
From good to better: Screening for ESG in low-volatility pool
On their own, minimum volatility strategies typically underweight certain sectors that include companies that, in addition to being relatively volatile, tend to have higher carbon emissions and other ESG issues. Energy and materials are two common examples. So any minimum volatility index will naturally show some improved ESG performance simply due to those underweights.
“Our enhanced ESG approach goes one step further, however, and allows us to pick the higher ESG and lower carbon emission securities in lower volatility sectors, such as utilities and consumer non-cyclicals,” says Smart. “Utilities is the easy example; these companies are often the highest contributors in terms of carbon emissions, but with low volatility they tend to pop up in traditional min vol strategies.” By applying ESG screening to reduce the impact of these companies, an ESG min vol index can achieve even higher ESG scores while still delivering strong risk-adjusted returns.”
A core index for Institutional portfolios
Institutional investors have been using BlackRock’s parent min vol ETF, USMV, as the core holding in their portfolios for more than a decade. “It’s been very successful, particularly for investors that are looking to control the overall level of risk in their US exposure, or for investors that are seeking just outright better risk-adjusted returns,” says Smart. “As a core replacement, you can also use ESMV at the heart of your portfolio. Given investors increasingly have ESG objectives, having ESG incorporated into min vol right at the core of the portfolio is a successful strategy that I think we’ll see implemented more and more.”
Alternatively, ESMV can play specific tactical roles in an institutional portfolio when serving as a complement to the core holdings, Smart notes. “From a tactical standpoint, for example, we think it’s an attractive ETF for institutional investors that are looking for higher risk-adjusted returns but also want to express an ESG perspective in their portfolio, or have ESG mandates but are still seeking differentiated exposure to the market from a risk-adjusted perspective,” he says. “Our iShares portfolio consulting team can help investors understand how a min vol ESG strategy fits into their broader portfolio and aligns with their specific goals.”
Looking to the future
“We believe that the low-risk anomaly will persist because of elements like structural impediments and behavioral biases of investors,” says Smart. He notes that institutional investors managing, say, pensions, have high return targets but are often constrained from using things like leverage. “So In order to meet their higher return targets, investors typically overweight higher volatility stocks and tend to choose flashier, riskier stocks, even if the odds are actually stacked against them. This leaves the lower-risk names relatively underpriced, with a higher expected return per unit of risk,” Smart explains.
Accordingly, the min vol factor strategy will continue to be a vital tool for institutional investors and may gain even wider use. “Since the inception of USMV in 2011, we’ve expanded the min vol strategy to ex-US markets with EFAV and EEMV, and they’ve both delivered higher risk adjusted returns than their respective benchmarks.”
As for ESG, commitments among institutional investors will only likely increase in the coming year. “One of the best indications comes from looking at some of the alliances that are formed around net zero, particularly in the institutional spaces,” says Smart. “We’re seeing asset managers and asset owners increasingly make commitments to organizations such as Glasgow Financial Alliance for Net Zero.”
As institutional investors are increasingly looking at ESG from a risk-return lens, the benefit of generating market-like returns while fulfilling increasingly complex mandates is the most compelling draw for many asset managers in the institutional community. “There are several wins for institutional investors in combining ESG with min vol,” says Smart. “The low-risk anomaly, coupled with the high correlation between low volatility and better ESG attributes, offers the potential for investors to deliver a portfolio with superior ESG characteristics than the market while simultaneously seeking to drive higher risk-adjusted returns.”
1 [[need copy of the GBI report]]
[ON(C1]The number seems small. I see 100 Sustainable ETFs were launched in EMEA in 1H 2021 from the GBI report.
[GR(2]I inserted the new numbers. I can’t locate the specific GBI report that gives this figure — 100 Sustainable ETFs were launched in EMEA in 1H 2021 — Can you please send me the report or the citation so we can use it in the footnote?
