Rob Arnott, the so-called 'godfather of smart beta’ has said the majority of ESG managers are getting this style of investing wrong by following strategies he called ‘wishful thinking.’
Arnott, founder and chairman of Research Affiliates, said many ESG investors today were too focused on the environmental and social aspects of companies, but that there was no reason why companies that scored well in these regards would offer higher returns.
He said more attention should instead be paid to governance as well as diversity, a criterion he suggested should be added to acronym, so it would be called ESGD.
He called himself a huge fan of governance and diversity, arguing they were likely to be reliable sources of alpha.
‘If you want to change society with your money, ESG makes total sense,’ he told Citywire. ‘If you think it’s going to boost returns, be careful, because an environmentally sensitive portfolio, there’s no reason that should have higher returns, a socially sensitive portfolio, why should that have higher returns?’
‘They will have higher returns if there’s a tailwind for money flowing into the strategies, pushing up the valuations, but that’s a temporary alpha,’ he added.
In April, Research Affiliates launched a range of new ESG indices, the RAFI ESG indices, and plans to launch a standalone RAFI Diversity index later in the year.
Arnott, said the firm entered into the space due to client demand a belief that other ESG fund managers were making mistakes.
‘The vast majority of players in the industry don’t use ESG with an eye towards [asking], “How do we turn this into a reliable alpha engine?” It’s more wishful thinking that environmentally sensitive companies will have higher returns,’ he said.
'Lazy' index funds can beat the market
Speaking at the 2018 Inside Smart Beta conference, Arnott suggested index fund managers could boost returns for investors if they were ‘lazy’ and delayed certain trades.
Presenting his latest research project called ‘Buy High, Sell Low With Index Funds,’ Arnott argued that funds that immediately made trades in order to exactly match an index ended up paying a high price for new stocks and selling out of positions at a low cost.
He explained that when an index announced changes to its composition, the stocks being added were ‘popular, beloved, trendy names’ that were already expensive and which became more so on being added to index. Whereas those companies being traded out were ‘in the doldrums’ already and suffered further price drops when they left the index.
Thus, he argued, index funds that followed an index change immediately would end up buying the new stocks for a high price and selling the old ones for a low price.
This, he said, could be avoided by waiting a few months or more before making the same trade.
‘When the S&P announces the change [to the index], put up a post-it note on my calendar for next year and I’ll make this trade a year from now,’ he said.
‘That simple expedient adds about 20 basis points a year, you can get the S&P plus 20. The strategy is just by being lazy about trading,’ he said.
‘Of course, if everyone tries to do it, the alpha disappears but if some scrappy indexer who wants to make a name, wants to pursue these micro strategies, they can seek to deliver S&P plus 20 with about 30 basis points tracking error, that’s cool.’