Investors are increasingly using factor investing to integrate environmental, social and governance investing (ESG) within their factor portfolios, according to the latest Global Factor Investing Study from Invesco.

In 2021, 78% of institutional investor respondents indicated they incorporated ESG in their overall portfolios, and a further 19% were considering doing so.

While in previous years, the key driver behind ESG had been demand from stakeholders and beneficiaries, the current findings show that the most important motivation is the belief that ESG potentially enhances long-term investment performance.

Georg Elsaesser, senior portfolio manager, quantitative strategies, at Invesco, said ESG and factor investing are a very powerful combination.

He told IPE: “Risk and return of factor portfolios are determined by factor exposures. Hence, if you replace stocks scoring poorly on ESG by those scoring well and keep these exposures, you maintain the same risk/return expectations, while likely enjoying a windfall profit from better performance through ESG.”

The study – Invesco’s sixth – is based on interviews carried out between March and May 2021 with 130 institutional and 111 wholesale factor investors responsible for managing over $31trn (€26.5trn) in assets.

It shows that factor allocations are continuing to rise across the board.

Over the past year, 42% of all institutional investors had upped allocations, while 36% were planning an increase in the next 12 months.

According to Elsaesser, better risk management is a prime reason behind rising allocations, with 93% of institutional investors saying their aim was to reduce or optimise risk, especially in fixed income.

“The COVID market correction in March 2020 was a wake-up call for fixed-income investors and has led to a greater focus on managing risks, for example through improving credit quality by adding a quality factor,” he told IPE.

“Introducing ESG generally means a tendency to lower yields, but this can be mitigated by using factors, such as adding carry bonds,” he added.

A further driver, cited by 86% of institutional investors, is to increase returns.

“The fixed income space has seen a 30-year bull market, with interest rates falling over the years,” said Elsaesser. “Now rates have bottomed out and are going up again, and respondents are looking for alternative sources of income through factor investing.”

Invesco office

57% of institutional investors now use factors within their fixed income portfolios, up from 37% in the previous survey

The study found that 57% of institutional investors now use factors within their fixed income portfolios, up from 37% in the previous survey.

The survey also revealed a rapid uptake of a multi-factor approach, with nearly half (47%) of institutional investors already using a strategy which allows for a variation in exposures, while a third change their exposures regularly. This trend is set to accelerate, with 46% expecting to be more dynamic over the next two years.

Rising allocations to value are a strong trend, 39% of institutional investors having increased their allocations to the value factor in the previous 12 months, and 46% saying they were doing so in preparation for a post-pandemic recovery.

“In recent years, value stocks underperformed because it was a growth, momentum market with overall high risk aversion,” said Elsaesser.

“And the COVID outbreak prompted a value crash. But in November 2020, the news of Pfizer-BioNTech’s successful vaccine trials gave investors the confidence to start taking risks, and they started allocating to value again,” he noted.

Meanwhile, there is a continued momentum around factor ETFs as a tool to implement factor strategies, with 46% of institutional investors planning an increase in ETFs use over the next three years.

Looking at shifts in sentiment over the past five years of the study, Elsaesser said the outstanding trend was that ESG is more prominent than ever.

“Five years ago, hardly anyone mentioned it, but now it is front of mind,” he told IPE. “I would expect it to be a standard feature of portfolios in the next couple of years.”

The first Invesco study, in 2016, had also shown a concern among investors that factor investing could become a crowded space.

“This fear has not been realised, and in fact crowding concerns appear to have decreased over the years,” Elsaesser added. “The performance recovery in recent months has been very positive for the popularity of factor investing, but it still makes up only a fraction of the market.”

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