How to integrate a low-carbon objective into factor investing

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One of the great features of factor investing is that it can be adapted flexibly to a variety of investment universes, styles and constraints, while keeping constant track of the associated costs. The reason for this flexibility lies in the fact that in the investment process, the factors provide an ‘opinion’ on every stock in the investable universe.

So, when a portfolio constraint is added, prohibiting, for example, investment in a given stock, it is always possible to find another stock with similar factors and the same profile in terms of its behaviour in a global portfolio. This crucial attribute is comprehensively explained in the research paper published by our Financial Engineering team in 2014 in the Journal of Asset Management, “An integrated risk-budgeting approach for multi-strategy equity portfolios”.

Greater awareness of carbon footprint

One permutation of factor investing currently attracting interest among investors is low-carbon investing. Following the COP21 summit held in Paris last December, many institutional investors have become more aware of their portfolio’s carbon footprint – typically measured by the carbon emissions of the underlying companies – and want to reduce it.

ERAFP, the French public sector pension fund, has led this trend in France and to spread the word, it has sponsored a new am-league notional mandate to promote low-carbon investing among institutional investors in a transparent way. The interesting feature of this paper-trading game is the combination of three objectives, namely: adhering to the principles of socially responsible investing (SRI), reducing the carbon footprint and generating excess investment performance.

Combing SRI and low-carbon objectives and factor investing

In collaboration with the SRI teams at BNP Paribas Asset Management, THEAM is one of the more than 20 asset management companies taking part in this competition with a strategy based on our multi-factor model, while applying BNPP IP’s standard SRI and low-carbon philosophy to arrive at sector ranking. The strategy targets  a 5% tracking error relative to the relevant world equities benchmark (the STOXX Global 1800 index) of which roughly half is used to comply with the SRI and low-carbon guidelines, with the remaining half used to attribute risk equally to the four ‘right risk’ factors: low volatility, value, quality and momentum. The result is a well-balanced investment style.

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Source: www.am-league.com, as at 8 March 2016.

The competition only began last December, but we expect this strategy to outperform both the benchmark and the peer group, demonstrating how factor investing can be combined with active investment management to create new and efficient, integrated solutions. As of this February, the strategy ranked second in the competition. If you want to follow the real-time score of this international contest, you can access it here.

Etienne Vincent

Global Head of Quantitative Management

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