As interest in sustainability picks up, Asian investors are beginning to ask their fund managers whether environmental, social and governance (ESG) factors can be further integrated into the management of their portfolios.

In a recent roadshow in Hong Kong, Mario Andreetto, chief executive officer of index provider Stoxx Ltd, was surprised to see investors’ growing interest in sustainable investing and ESG. They are also asking smarter questions.

“At all the meetings I have on this trip, there is always a question on ESG, and this is a new development. I have never experienced this before in Hong Kong,” Andreetto says in an interview with The Asset.

One question that was repeatedly asked, and fascinated Andreetto, was whether ESG is a factor or not in the context of smart beta investing.

This question is interesting on a number of levels. First, it indicates that investors are keenly interested in ESG investing. Second, it also indicates that investors are looking at using ESG together with smart beta investing.

But responding properly to this question requires taking a step back and reviewing what “factor” means in the context of smart beta investing and how that fits into the strategy. Experts agree that a factor is an element that allows a fund manager to categorize assets, particularly equities, by their principal characteristics.

Examples include the value factor, which is used for categorizing value stocks; the low volatility factor for low volatility stocks; and the momentum factor for momentum stocks. Smart beta investing uses factors, such as value, low volatility or momentum for portfolio construction. (To learn more about smart beta, see TheAsset.com/Plus/smart-beta) Well-established factors, such as value, low volatility and momentum, are supported by extensive data and research covering long periods and numerous market cycles.

“To be defined as a factor, it is required that its factor premia has to be well-documented by very rigorous academic research. There should be economic rationale, or even financial theory, to support why this factor exists. For example, some factors show that it bears some systematic undiversifiable risks so that by bearing the risks, investors are rewarded with the returns associated with it,” says Taie Wang, vice president and deputy head of research at State Street Global Advisors.

Studies and research on ESG are still relatively new, having started only in the early 1990s. At that time research focused more on the risk implications of ESG. The next phase of ESG research took place in 1990-2000 and focused on whether ESG has positive financial benefits.

“Compared with studies on traditional factors, the research on ESG is still very lean. It’s not until recently that we had the explosion of ESG data. ESG is relatively new and its status as a factor is still debatable. We believe that we still need to do more research and more studies before ESG can be defined as a factor in the strictest way,” Wang says.

However, ESG can be loosely considered a factor when viewed only from the perspective of its attributes that relate to the environmental, social and governance.

“In this sense it can definitely be called a factor. It can also be incorporated in your investment strategy, just like you do with other factors, and incorporated into your investment decisions or portfolio construction. From this perspective it can be loosely called a factor,” Wang says.

On the other hand, Northern Trust is of the belief that ESG is a factor, but it is unique based on the fact that there is no simple definition for ESG as a corollary to how the industry might define a value factor by “price to book”, for example.

“That said a factor is a characteristic that explains risk and/or return. We, and others, have identified elements within ESG that have risk and return explanatory power. We see growing demand and quantitative application for inclusion of ESG as an extension of our factor-based investment platform,” says John McCareins, managing director and head of Asia-Pacific, Northern Trust Asset. Management.

The experts agree that ESG can still be used for portfolio construction although its status as a traditional factor is not yet established.

For example, investors can use ESG scores that can be incorporated into their portfolio construction in conjunction with traditional factors.

“Based on our studies we have found that ESG is naturally aligned with key factors. For example, our studies found that companies with higher ESG scores tend to have lower valuation, tend to be of higher quality, lower volatility, and of relatively large size. So, it’s aligned with the factors, therefore you can certainly build ESG into your factor portfolio,” Wang says.

Another example is governance, which is an acute consideration in Asia and emerging markets, given the number of state-owned enterprises and companies exhibiting high shareholder concentration and thereby control.

“We have conducted research identifying the risk and return implications from a factor lens. We have seen high adoption of our emerging markets smart beta strategies, of which Asia is a high exposure, designed to mitigate these governance risks,” McCareins says.

ESG can also be used as a factor for screening companies with poor environmental, social, and governance practices, thus, guaranteeing a positive ESG exposure to the portfolio.

“Some investors will find that ESG is a nice complement to quality factor, for example. Some investors look at quality from the fundamental perspective and ESG can measure a company’s quality from a non-financial perspective. So you can definitely complement your quality factor with the ESG component. That’s another way to build ESG into your investment portfolio,” Wang says.

These examples are not lost on Asian financial institutions who are seeking to incorporate more ESG into their investment portfolios.

The Bureau of Labor Fund (BLF) of Taiwan, for example, has awarded a US$2.4 billion “Global ESG Quality Mix Equity Indexation Mandate” designed to establish a corporate social responsibility-oriented investment and to respond to a low-rate environment.

In this connection, BLF selected MSCI as the benchmark provider for the mandate which means it will use MSCI’s ACWI ESG ex Selected Sub-Industries Quality Mix E Series Capped Index. The mandate marks the first time the BLF, which oversees public funds with assets of roughly US$100 billion, is launching a set of funds with ESG factors as a main part of the investment criteria to be invested in global markets. The mandate also represents the first multi-billion-dollar mandate in Asia that combines ESG and multi-factor strategies.

In addition, Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund with US$1.3 trillion in assets under management, plans to raise its allocation to environmentally and socially responsible investments to 10% percent of its stock holdings from its current level of 3%.

“ESG interest continues to grow but it varies across Asia-Pacific markets. Australia and New Zealand, for instance, are in the integration and application stage. We see markets like Japan in the research and adoption stage. Other markets in Asia we find are in the discovery stage,” McCareins says.

But despite the surge in interest on ESG investing among Asia-Pacific investors, Asia-Pacific still lags behind Europe and the US in terms of ESG investing, except for the more developed markets of Australia, Japan, and New Zealand.

There is also a need for more investor education as investors demand more information, data and research that will be useful to them as they seek to further incorporate ESG into their portfolios.

When asked what other types of questions their Asia clients are asking about ESG, Andreetto replies that the questions are wide-ranging and show an advanced level of understanding.

“Everything. They’re asking about products, costs, indirect benefits, and others. They also ask: Can we overlay ESG with minimum variance for example? That’s quite advanced,” Andreetto says.