New Trends in Asset

Management
From Active Management
to ESG and Climate
Investing

Enrica Bolognesi
New Trends in Asset Management
 Enrica Bolognesi

New Trends in Asset

Management
From Active Management to ESG and Climate
Investing
Enrica Bolognesi
Department of Economics
and Statistics
University of Udine
Udine, Italy

ISBN 978-3-031-35056-6 ISBN 978-3-031-35057-3 (eBook)

https://doi.org/10.1007/978-3-031-35057-3

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 Contents

1 Introduction 1
2 The Impact of Index Design on Asset Management 7
What Is a (Good) Benchmark? 9
Cap-Weighting: Pros and Cons 11
Cap-Weighting and Financial Bubbles 12
Cap-Weighting and Diversification 14
Beyond Cap-Weighting: Alternative Index Weighting Schemes 15
References 21
3 Pros and Cons of Active Management 23
Main Issues in Active Management 27
Higher Costs and Underperformance 27
Herding Behaviour 29
Incentive Schemes and Short-Terminism 32
Mispricing, Market Anomalies, and Behavioural Managers 35
References 36
4 Searching for Market Drivers: Factor Investing 39
The Theory Behind Factors 40
Fama–French Three-Factor Model: An Application
to Alternative Weighting Schemes 43
Smart Beta and Factor Investing 45
Factor Investing and the Asset Management Industry 47
Factor Indexing 49

v
vi CONTENTS

Factor Investing: A Back-Test Exercise 53

References 56
5 Hybrids Increasingly Blurring Active/Passive Line 59
Index Portfolios and Exchange-Traded Funds 60
The Active–Passive Investment Line 63
Core-Satellite Strategy 65
Smart Beta ETFs 66
Active Exchange-Traded Funds 68
Further Statistics 70
References 71
6 The Need for a Change: Sustainable Finance 73
Sustainable Investing 75
Origins and Evolution 75
ESG Factors 80
ESG Disclosure 83
The Impact of the ESG Integration on Financial
Performance 84
The Impact of Regulation on ESG Disclosure 87
References 91
7 The Next Challenge: ESG and CLIMATE Investing 95
ESG Investing 96
ESG Ratings: Main Actors and Methodologies 96
ESG Ratings: Diverging Evaluations and Size Effect 100
Responsible Investment Strategies 101
ESG Investing and Regulation 103
Climate Investing 106
New Frontiers on Indexation 109
References 115

References 117
Index 125
 List of Figures

Fig. 2.1 Performance of information technology stocks (Source

Bloomberg data. Author computation) 12
Fig. 2.2 Sectorial weights dynamics (Source Bloomberg data.
Author computation) 13
Fig. 2.3 Sectorial weights and price/earnings ratios (Source
Bloomberg data. Author computation) 14
Fig. 2.4 FAANG stocks vs Nasdaq 100 Index (Market cap
and weights of the FAANG vs Nasdaq 100 Index. Source
Bloomberg Data. Author computation) 15
Fig. 2.5 Performance of alternative US equity market indexes
(2003–2023) (Source Bloomberg data. Author computation) 19
Fig. 2.6 Risk-return profile of alternative index construction
methodologies (2003–2023) (Analyses are based on weekly
returns. Returns and standard deviations are annualised.
Source Bloomberg data. Author computation) 21
Fig. 4.1 Factor investing as a middle ground between active
and passive investing (Source Author’s elaboration) 47
Fig. 4.2 The Morningstar’s style box investing (Source Morningstar
website) 48
Fig. 4.3 Factor indexes: Risk-return profile (Analyses are
based on weekly returns. Observing period: January
2003–January 2023. Source Bloomberg Data. Author
computation) 55
Fig. 5.1 Active vs passive equity funds: AuM (Source Author’s
elaboration on Bloomberg data) 62

vii
viii LIST OF FIGURES

Fig. 5.2 ETFs industry: AuM (Source Author’s elaboration

on Bloomberg data) 62
Fig. 5.3 Geographical focus of ETFs: AuM (Source Author’s
elaboration on Bloomberg data) 63
Fig. 5.4 Size focus of ETFs: AuM and percentage (Source Author’s
elaboration on Bloomberg data) 64
Fig. 5.5 Core-satellite strategy (Source Author’s elaboration) 65
Fig. 5.6 Smart beta ETFs: AuM (Source Author’s elaboration
on Bloomberg data) 67
Fig. 5.7 Smart beta vs sectorial ETFs: AuM (Source Author’s
elaboration on Bloomberg data) 68
Fig. 5.8 Active ETFs: AuM (Source Author’s elaboration
on Bloomberg data) 69
Fig. 5.9 Active vs passive investing (Source Author’s elaboration
on Bloomberg data) 70
Fig. 6.1 ESG pillars and sub-topics (Source Author elaboration) 81
Fig. 6.2 Boxplot visualisation of ESG disclosure scores by year
(Source Author’s computation on Bloomberg data) 90
Fig. 7.1 EU regulatory framework on sustainable finance:
A timeline (Source Author’s elaboration) 104
Fig. 7.2 EU Taxonomy: Environmental objectives (Source Author’s
elaboration) 107
Fig. 7.3 Sustainable investing and indexation (Source Author’s
elaboration) 111
Fig. 7.4 Risk-return profile of alternative sustainable indices
(2013–2023) (Source Author’s elaboration on Bloomberg
data. Analysis based on weekly returns) 113
Fig. 7.5 Tracking error and tracking error volatility of sustainable
indices (2013–2023) (Source Author’s elaboration
on Bloomberg data. Analysis based on weekly returns) 113
Fig. 7.6 Tracking error and tracking error volatility of sustainable
indices (2021–2023) (Source Author’s elaboration
on Bloomberg data. Analysis based on weekly returns) 114
 List of Tables

Table 2.1 Return characteristics of alternative index construction

methodologies (2003–2023) 20
Table 4.1 Comparison between alternative weighting schemes 44
Table 4.2 Factors and indexes description 54
Table 7.1 The sample of sustainable indices: description 112
Table 7.2 Comparison between sustainable indices 115

ix
 CHAPTER 1

Introduction

Abstract This chapter provides an overview of the topics covered in

this book. The book is structured into seven chapters. We start with
the first investment strategies that have characterised the asset manage-
ment industry, typically based on diversification and on the manager’s
skills to select the best investment opportunities. Since then, academic
research and the asset management industry have actively influenced each
other by creating ever more sophisticated products and tools suitable for
investors more involved in financial market trends. This path traverses the
themes of the importance of the benchmark’s construction methodologies
and passive investing that have experienced an extraordinary evolution
to move ever closer to the active management schemes. Finally, the
emphasis is placed on the issue of sustainable finance and the tools used
by managers to offer investment products committed to the fight against
climate change.

Keywords Asset management industry · Benchmark · Active and passive

management · Sustainable finance

This book aims at describing the evolution of the asset management

industry over time, aiming to integrate two different perspectives, that
of academic research and that of institutional investors. Academics and

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2 E. BOLOGNESI

asset managers have contributed to the evolution of this industry by

creating increasingly intertwined common paths that are stimulus for
the progress of the other. In fact, retracing the most important steps
of this evolution, we realise that, on the one hand, empirical research
has had a substantial impact, suggesting and stimulating portfolio allo-
cations with increasingly evolved risk and return profiles. On the other
hand, asset managers have been able to quickly integrate the results of
academic research, launching ever new investment strategies and products
to broaden their offer. Observing this evolution, we focus on traditional
asset management products, i.e., mutual funds, because they are created
for retail investors and, therefore, for whom collective asset management
was born. In fact, mutual funds allow small investors to pool their money
and benefit from diversification and from the expertise of professional
asset managers.
The asset management industry has been developing since the 1970s;
portfolio allocation was mainly based on the principle of financial diversi-
fication introduced by Markowitz in the 1950s. With the Capital Asset
Pricing Model (CAPM) and its subsequent evolutions, asset managers
have started to try to identify the ‘market portfolio’, i.e., the optimal,
efficient, and desirable portfolio on which to base their asset allocation.
Given the unrealistic opportunity of creating a portfolio that contains all
investable assets, the choice shared by the industry has been to associate
market indices with the concept of an optimal market portfolio. In addi-
tion, a choice that had a significant impact on asset allocation has been
the use of the benchmark for risk and performance assessment, a tool that
has assumed ever-increasing importance.
For these reasons, Chapter 2 focuses on the role of the benchmark
in the asset management and on some alternative index construction
methodologies. Cap-weighting, the most commonly used methodology,
leads to portfolio allocations that favours large-cap stocks, in the belief
that the firms’ size can be used as a proxy of its representativeness in the
reference market. While, on the one hand, this approximation is plausible
and easy to implement, on the other it generates distortion effects that
can impact negatively both on financial markets and on portfolio diver-
sification. In fact, when we assist in decreasing investors’ risk premiums,
large flows of savings are quickly channelled towards mutual funds and,
thus, mainly to large caps, since they show higher weights in the bench-
marks. This can lead to an upward spiral in the prices and stock valuations,
favouring speculative bubbles, such as the well-known .com bubble. As far
 1 INTRODUCTION 3

as diversification is concerned, the risk is that the weight of these stocks

becomes so high that they represent an excessively large portion of the
overall market index, sacrificing the weight of the other components. We
therefore focus on alternative index design methodologies, based both on
the representativeness of the index components and on the efficiency of
the portfolio. A comparison of the risk-return profile of these indices is
provided, emphasising the differences.
Chapter 3 focuses on active management being the oldest investment
philosophy. The aim is to underline the advantages and disadvantages of
active portfolio management being the strategy based on the research of
the creation of value for the investor through active choices. Active bets,
meant as deviations from the benchmark composition, should allow for
excess returns able, at least, to compensate the management fees applied
to the fund. Academic research has emphasised many of the problems
affecting active management being based on the expectations of asset
managers on market trends or on their ability in stock picking. Indeed,
because active management is the result of human choices, academic liter-
ature has emphasised some behavioural bias affecting portfolio managers.
In addition, the performance statistics for active funds have been disap-
pointing over time as a very small percentage of asset managers has
demonstrated the ability to beat the market.
Chapter 4 focuses on an important evolution in active management
called factor investing. In particular, the aim here is to describe the
evolution of the academic research from the CAPM towards multi-factor
models, with a particular emphasis on the three-factor model of Fama
and French of 1993. This multi-factor pricing model has had a signifi-
cant impact on the overall asset management industry; just consider that
the two factors that we know today as the first investment styles in equity
management were born from it, namely size and value. Hence the birth of
factor investing in asset management, that involves selecting stocks based
on their exposure to specific factors or characteristics, rather than simply
buying a diversified portfolio of stocks. Empirical research has demon-
strated that factors are persistent and pervasive drivers of return. The
basic idea behind the factor investing is to identify securities that exhibit
strong exposure to a particular factor and to construct a portfolio that is
overweight in those securities. In particular, factor investors use quanti-
tative techniques to identify factors that are expected to generate excess
returns, but do not rely on individual security selection or market timing
to achieve these returns. Instead, they aim to capture the systematic and
4 E. BOLOGNESI

persistent returns associated with certain factors over time. The imple-
mentation and diffusion of this investment strategy have been supported
by the creation of factor indices to be used as benchmarks. Thus, we
observe the characteristics of the main indices supporting factor investing.
From the asset manager’s perspective, factor investing is a sort of middle
ground between passive and active management.
Chapter 5 continues in this direction showing the persistent marked
intersection between active and passive management. The first part
is dedicated to the description of the exponential growth of passive
management supported by the growing preference of investors towards
this industry. We focus on the birth of the Index Funds and the
Exchange-Traded Funds (ETFs), providing several statistics on the asset
under management flowing to passive investing, especially considering
the equity markets. ETFs have indisputably become a leading form of
investment and are greatly appreciated among investors thanks to their
simplicity. In fact, they are low-cost, comprehensive, diversified portfolios
and able to permit an exposure to various market segments. Moreover,
they can be traded on an intraday basis. As highlighted, active manage-
ment suffers from some difficult challenges such as investing in active
funds seems to have ‘little economic sense’ especially if the returns are
evaluated with respect to a market index. This statement is supported by
the fact that, operationally, the adoption of a benchmark has the effect
of anchoring the asset manager to the benchmark composition due to a
multitude of technical and psychological factors. The close link existing
between the fund and the benchmark, therefore, determines a substan-
tial flattening of the portfolio’s composition towards its benchmark. The
perception by investors of generalised semi-passive management, which
effectively does not allow for the achievement of sufficient overperfor-
mance to repay the management costs, helps to explain the strong growth
in the volumes invested in passive funds. In other words, what we have
witnessed has been a progressive disaffection of investors towards active
funds. The next step of the industry has been the launch of hybrid prod-
ucts such as Smart beta ETFs, following rules-based investment strategies
that seek to capture specific factors or characteristics that are believed to
drive returns. Furthermore, the latest products born, which effectively has
crossed the line between active and passive management are Active ETFs.
It follows that, rather than a black-and-white choice, active management
is getting more passive, and passive is getting more active.
 1 INTRODUCTION 5

Chapter 6 attempts to address the role and the growth of sustainable

investments, nowadays a popular term that is meant to include all forms
of socially responsible investing and ESG-oriented investing. Environ-
mental Social and Governance integration means that these three factors
are able to affect the investment decisions of financial analysts and port-
folio managers. Accordingly, asset managers use ESG disclosure because
of client demand or as part of their product development process. Proof of
the large and growing market interest in the level of a company’s degree
of transparency about its ESG performance and policies is the exponen-
tial growth of assets under management that incorporates some element
of ESG review and decision-making. Thus, we focus on the impact of the
ESG disclosure scores on financial performance. Furthermore, we show
the impact of regulation on disclosure, comparing the average scores of a
broad sample of US and European firms.
Finally, the last chapter aims at addressing the new challenges of
the asset management industry, i.e., ESG investing and, more recently,
climate investing. If ESG investing is guided by the search for compa-
nies active on the three pillars, climate investing refers to the investment
in companies, projects, and technologies that are focused on reducing
the negative impact of climate change. Climate investing is an important
part of the broader sustainable investing landscape, as it seeks to address
one of the most pressing environmental challenges of our time. Climate
investing is driven by the recognition that climate change poses signif-
icant risks to the global economy and society, and that urgent action is
required to mitigate these risks. The investment community is increasingly
focused on climate investing as a way to align financial returns with envi-
ronmental and social goals. We firstly focus on the main ESG rating and
their differences. ESG ratings often lack transparency in their calculation
and differ substantially in the metrics on which they draw, as well as the
methodologies used in their calculation, raising questions as to the extent
to which their aggregation contributes to long-term value. Methodolo-
gies also tend to differ substantially across rating providers and result in
a lack of correlation between ESG ratings supplied by different providers.
Finally, we provide evidence of the growth of this new theme of invest-
ment, observing and describing the most recent ESG and climate indices
launched.
 CHAPTER 2

The Impact of Index Design on Asset

Management

Abstract This chapter focuses on the impact of different equity index

construction methodologies on the risk-return profile of managed port-
folios. The first step is to define the characteristics that a market index
must show to be used as benchmark in the asset management industry.
Secondly, we critically analyse the main threats originated by using an
equity market index composed according to the market cap of its compo-
nents. The analysis of the impact of this methodology is extremely
important because of their widespread use by institutional investors. In
particular, the focus is on the distortions in their composition gener-
ated by overvalued securities (which can fuel financial bubbles) and on
the risk of low diversification. Moreover, we provide evidence of the
differences between alternative index construction methodologies, such
as methodologies based on market representativity and on portfolio
efficiency.

Keywords Benchmark · CAPM · Market portfolio · Index design ·

Cap-weighting

Gains and losses that come with holding the benchmark portfolio are an
‘act of God’.

© The Author(s), under exclusive license to Springer Nature 7

Switzerland AG 2023
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8 E. BOLOGNESI

Gains and losses that come with deviation from the benchmark portfolio
are an ‘act of man’.
(Clarke et al., 1994)

This statement summarises well the crucial role of the benchmark port-
folio in asset management. We can see the benchmark acting as a pivot
around which the portfolio manager constantly rotates, searching for
value for the portfolio subscribers. In fact, the portfolio construction
starts from the benchmark’s composition and constantly develops around
it. The benchmark establishes the absolute performance of the invest-
ment, the ‘act of God’; asset managers are responsible for the portfolio’s
relative performance, the ‘act of man’, which is the result of the devi-
ation of the managed portfolio from the benchmark. Its relevance has
grown together with the exponential growth of the asset management
industry worldwide. In fact, a reference parameter is required consid-
ering each aspect of portfolio management, from its construction and risk
monitoring to the communication with subscribers. Thus, asset managers
consider the benchmark as the optimal portfolio.
Since the 60s, the insights stemming from the Modern Portfolio
Theory (Markowitz, 1952) and the Capital Asset Pricing Model (Lintner,
1965; Sharpe, 1964) have led to the consideration of the market port-
folio as the mean–variance optimal portfolio. According to the CAPM,
the entire market is one in which all risky assets, such as financial assets,
consumer durables, real estate, and also non-traded assets like human
capital are included. Thus, in reality, the market portfolio is unobservable
and the possibility to test whether it is mean–variance efficient is also prac-
tically impossible. For this reason, the market portfolio is approximated
by market indexes that represent a broad cross-section of the market. The
most common approach is to use cap-weighted market indexes, (i.e., the
S&P500 and the MSCI World) as proxies for the market portfolio. Cap-
weighted market indexes are calculated by taking the market value of each
company in the index and weighting it by its market capitalisation relative
to the total market capitalisation of all companies in the index. Thus, cap-
weighted market indexes overweight large-cap stocks and underweight
small-cap stocks.
On the one hand, nowadays cap-weighted indexes have become an
integral part of the investment process of long-term institutional investors
such as mutual funds, pension funds, and insurance companies; it is a
widely accepted methodology because it is a practical approach that allows
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 9

for easy comparisons of investment performance against a market bench-

mark. On the other hand, the choice of an index is strategic because it
has a critical impact on the portfolio construction, on the risks assumed,
and, overall, on the final performance. Investors who seek to construct
portfolios that are more representative of the true market portfolio may
consider using alternative weighting schemes or broader market indexes
that include a wider range of assets beyond traditional stocks and bonds. It
is therefore worthwhile to dwell first on the characteristics that a market
index must show in order to be a good benchmark and, hereafter, on
alternative index construction methodologies.

What Is a (Good) Benchmark?

We define a benchmark as an index, composed with reference to
commonly used financial indicators and developed by third parties. The
benchmark is a basket of securities, representative of one or more markets
or asset classes. Benchmarks must be aligned with the investment objec-
tives and risks associated with the managed portfolio. Over time, the
benchmark has increased its role as a communication vehicle between
asset managers and subscribers of managed products.
Going into more detail on the role attributed to the benchmark, it is,
above all, the portfolio that encloses the set of investable securities. The
benchmark is usually a composite index, i.e., made up of several market
indices in different proportions. For example, the benchmark for equity
mutual funds is often composed of 95% of an equity market index and
5% of a money market index. The reason lies in the fact that, in this way,
the portfolio maintains liquidity (in this case of 5%) to face significant
redemptions. In the case of balanced portfolios, the composite benchmark
consists of two or more indices representative of equity and bond markets.
From the asset manager’s perspective, the benchmark is of primary
importance in investment decisions, because it defines the origin point
from which to measure the portfolio risk. This role is even more under-
standable if we consider that many portfolio managers are driven to leave
the portfolio’s absolute return in the background, because it is mainly
rewarded according to the deviation from the benchmark (i.e., extra
performance). Therefore, asset managers are led to evaluate their own
operational choices on a relative base, in terms of parameters such as the
tracking error volatility (i.e., the standard deviation of the portfolio’s extra
returns).
10 E. BOLOGNESI

From the investors’ perspective, a benchmark is a tool that allows,

firstly, a historical performance comparison. Additionally, in the case of
equity portfolios, the comparison of the portfolio with its benchmark is
based on the geographical/sectorial composition. In case of bond portfo-
lios, the comparison focuses mainly on the duration and the rating of the
issues. From this comparison, it is possible to understand the deviations
in the composition of the portfolio from its benchmark: these deviations
represent active bets . Furthermore, the comparison with the benchmark
is used for the calculation of incentive fees, if provided. This type of fee is
applied if the performance exceeds that of the benchmark and is usually
a percentage (typically 20%) of the excess return registered over a known
time frame.
One of the key issues for a managed portfolio in embracing a market
index as benchmark is its appropriateness. Generally, a market index
requires the submission of several guidelines such as: (1) being objective
and transparent, meaning that the benchmark should be clearly defined
and easily understood. This means that the benchmark must be calculated
by third parties, following rules that are not based on arbitrariness and are
easily understandable: the financial community must also be aware of its
composition and calculation rules, ex ante; (2) being representative of its
asset class, meaning that it should define the range of eligible instruments
specified by the investment targets; (3) being replicable and investible,
meaning that each asset should be eligible instruments and tradable;
(4) being computable and developed from publicly available informa-
tion, meaning that investors should be able to monitor the benchmark
portfolio and assess its exposures on a continuous basis.
The trade-off occurring between representativity and replicability is
straightforward: the greater the representativity of the basket of secu-
rities (due to a wide number of assets included), the less achievable is
the basket’s replicability, due to the greater number of tradable assets
and a feasible illiquidity risk. Similarly, the greater the number of index
components, the higher the transaction costs supported by the financial
portfolio. For instance, the Morgan Stanley Capital International (MSCI)
World Index, is one of the most popular benchmarks of international
equity funds, being composed of approximately 1500 stocks. The MSCI
World Small Cap Index has about 4500 members. The complexity of
investing and monitoring such a large number of assets is straightforward.
Focusing more in depth on representativity, this requirement is defined
as the ability to reflect the characteristics of a specific market (i.e., the
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 11

index components must reflect the investment opportunities available in

its defined market). In operational terms, the industry has associated the
representativeness of a firm with its size, choosing to focus on market-cap
indexes. Market cap-weighting is supposed to describe and summarise a
specific market, as larger firms assume higher weights on the index.

Cap-Weighting: Pros and Cons

As already mentioned, cap-weighting is justified by the Capital Asset
Pricing Model and its central conclusion is that the cap-weighted portfolio
of all available assets in the economy is a proxy of a mean–variance effi-
cient portfolio. However, from an operational point of view, cap-weighted
indexes are justified by their simplicity of use (both for replicability
and transparency) even if, from a theoretical point of view, this choice
has important implications. Using these indexes, investors should be
aware that cap-weighted indexes omit most of the assets available in the
economy, such as non-listed firms, social security, and private housing
which are instead included in the theoretical market portfolio.
On the one hand, this simplification is balanced by several advantages
that these indexes are able to offer. Firstly, usually market indexes are well
known by investors and allow for a better understanding of the investable
universe by the portfolio manager. Moreover, investors can diversify the
portfolio in a simple and inexpensive way, simply by purchasing shares
of the market portfolio, which will rebalance itself on a continuous basis
as the prices of its individual components vary. At the same time, the
index components are usually the largest caps in their market segment
and among the most liquid, given the high correlation between size and
liquidity. Finally, a further positive aspect of investing in cap-weighted
indexes is the fact that they are characterised by low trading costs, given
the passive nature of rebalancing deriving from the automatic adjustment
of weights based on asset prices. Indeed, some rebalancing costs must also
be incurred: at specific dates, some constituents are replaced with others
that become significant enough to deserve to be included in the basket, or
to completely eliminate some of the components following extraordinary
events such as mergers and acquisitions or spin-offs.
On the other hand, the cap-weighted methodology leads to several
drawbacks. Firstly, the investors’ preference for a particular investment
idea provokes a lower risk premium required by investors to hold the
asset. Consequently, asset valuations sour as do their weights in the market
12 E. BOLOGNESI

index. Moreover, cap-weighting can be too concentrated on large caps,

threatening the first aim of a market portfolio being representative and
well diversified. These two important aspects deserve a more in-depth
analysis.

Cap-Weighting and Financial Bubbles

The impact of cap-weighting on financial markets was clearly observed
during the burst of the so-called .com bubble. It was this event that
highlighted, for the first time in a straightforward way, the limitations
of cap-weighting. In a nutshell, the fever for .com stocks led to exces-
sive firms’ valuations due to the expectation for exponential firms growth
motivated by the new Internet era. Investors became overly enthusiastic
about those stocks whose prices soared to unsustainable levels due to
excessive speculation and positive sentiment.
Here it is worth retracing the experience of this financial bubble to
highlight the repercussions of the cap-weighted methodology from an
investor’s perspective. The objective is to correlate the prices, weights,
and valuations of stocks belonging to the Information Technology (IT)
sector. To do this, we first look at Fig. 2.1, showing the performance of
the sub-index, named S&P500 Information Technology Index, against
the S&P500 Index, around the creation and the burst of the financial
bubble.

Fig. 2.1 Performance of information technology stocks (Source Bloomberg

data. Author computation)
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 13

The outperformance of the internet sector, compared to the overall

US equity market, favoured an increase in the weight of the related
stocks, and components of the index. Figure 2.2 shows the trend of
the IT sector’s weight, within the overall S&P500 Index. It is easy to
notice the impact of the outperformance of the IT sector on its weight,
which has caused a sort of vicious circle between stock’s prices and stock’s
weight. The graph shows that this weight has constantly and significantly
grown during the late ‘90s, i.e., from 12.40% in December 1996 to
29.18% at the end of 1999. As a matter of fact, the first months of 2000
coincide with the peak of the ‘irrational exuberance’ as defined by the
Federal Reserve Board chairman Alan Greenspan a few years earlier, in
1996. In the speech, Greenspan raised concerns about the stock market
and the possibility that it was experiencing a bubble. He warned that
investors were becoming overly optimistic and that their behaviour was
not supported by the fundamentals of the economy.
The next step is to observe the relationship between weights and
valuations of the index components. In particular, Fig. 2.3 shows the
relationship between the average Price/Earnings ratio of each industry
and its weight within the S&P500 Index. The analysis is focused on the
three years before the Internet bubble burst (1997–1999). Observing the
graph, we see that the IT sector is characterised by an average higher
PE ratio with respect to the other industries. However, its valuation has
achieved extremely high levels in 1999, due to huge prices compared to

100
90
80 S&P 500 UT ILITIES INDE X
70 S&P 500 MA TERIALS INDEX
WEIGHT (%)

60 S&P 500 COMM SVC

S&P 500 ENERGY INDEX
50
S&P 500 INDUSTRIALS IDX
40 S&P 500 CONS STAPLES IDX
30 S&P 500 CONS DISCRE T IDX
S&P 500 HE ALTH CARE IDX
20
S&P 500 FIN ANCIALS INDEX
10
S&P 500 INFO TECH INDEX
-
1996 1997 1998 1999 2000 2001 2002
YEAR

Fig. 2.2 Sectorial weights dynamics (Source Bloomberg data. Author computa-
tion)
14 E. BOLOGNESI

Fig. 2.3 Sectorial weights and price/earnings ratios (Source Bloomberg data.
Author computation)

the firms’ expected earnings. This overestimation has resulted in a propor-

tional increase in the weights of these stocks into cap-weighted indexes.
Therefore, portfolio managers have been ‘forced’ to constantly invest in
these securities, also in the light of higher investors’ appetite for risky
assets during that period, to keep the portfolio’s risk-return profile in line
with the benchmark’s one. These two conditions, growth of the flows into
equity products and growth in their valuations, have led to an upward
spiral of overvalued securities’ weights.

Cap-Weighting and Diversification

Cap-weighted portfolios can also lead to a low diversification. In fact, one
of the most evident drawbacks of the cap-weighted methodology is the
high probability that large stocks become too heavily weighted into the
index providing a portfolio which is too concentrated on larger securi-
ties. An example is the dynamic of the aggregate weight of the five largest
and most popular technology companies, components of the Nasdaq 100
Index. These new high-growth stocks, known by the acronym FAANG,
are: Meta (formerly known as Facebook); Amazon; Apple; Netflix; and
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 15

Fig. 2.4 FAANG stocks vs Nasdaq 100 Index (Market cap and weights of the
FAANG vs Nasdaq 100 Index. Source Bloomberg Data. Author computation)

Alphabet (formerly known as Google). Figure 2.4 shows the relation-

ship between the FAANG and the Nasdaq 100 Index. In particular, the
first graph shows the dynamics of the aggregate market capitalisation of
the FAANG as part of the Nasdaq 100 Index. The observation period
is 10 years, starting from 2013, the year in which the term FAANG was
coined. The FAANG market cap has increased from 915bn in 2013 to
a maximum of 7trn in Q4 2021. The weight of the FAANG on Nasdaq
100 Index is shown in the second graph. It is striking to observe that the
total weight of just five stocks (out of 100), has reached, on Q3 of 2020,
the huge level of 42% of the Index.

Beyond Cap-Weighting: Alternative

Index Weighting Schemes
Since capitalisation is a function of the stock market price, cap-weighted
portfolios are to be considered optimal when the prices represent the
securities’ fair price and, therefore, when the hypothesis of market effi-
ciency is verified. As already mentioned, although market indexes have
been commonly accepted as the best proxy of the market, many critiques
have been put forward that highlight the weaknesses of the CAPM.
Among others, we recall Roll’s critique about the impossibility of creating
fully diversified portfolios. Roll (1977) argues that the CAPM is flawed
because it is based on unrealistic assumptions about market condi-
tions and investor behaviour. Specifically, Roll contends that the CAPM
assumes that all investors have access to the same information and make
investment decisions solely based on risk and return, without consid-
ering other factors such as market liquidity, taxes, or transaction costs.
16 E. BOLOGNESI

He argues that investors have varying levels of information and may have
different preferences or constraints that affect their investment decisions.
As a result of these limitations, Roll suggests more sophisticated models,
such as the Arbitrage Pricing Theory (APT), which allows for a wider
range of variables and factors to be included in asset pricing, and may
provide a more accurate representation of market behaviour.
A further critique of the CAPM comes from the Noisy Market
Hypothesis, which was introduced by Fischer Black in 1986, who claims
that market prices are not always efficient, but rather reflect the influ-
ence of noise traders who make investment decisions based on factors
other than rational analysis of information. Black (1986) argues that
this phenomenon can lead to short-term price movements that deviate
from the true value of assets and may affect the ability of investors to
make profits by trading on publicly available information. Similarly, Siegel
(2006) argues that the market portfolio as defined by Modern Portfolio
Theory is unrealistic and not representative of the actual market. In reality,
there are many assets that are not included in the market portfolio, such
as private equity, real estate, and commodities. Moreover, the weights of
assets in the market portfolio are determined by their market value, which
can be distorted by factors such as speculation and market bubbles. As an
alternative, Siegel proposes the concept of a ‘super portfolio’ that includes
all investable assets, both public and private, and weighs them based on
their economic importance. This approach, he argues, would provide a
more accurate representation of the market and a better foundation for
portfolio management.
Consistently, stock market prices tend to deviate from their fair values
creating mispricings. Hsu (2006) argues that stock prices are inefficient,
meaning that underpriced stocks show a smaller market cap with respect
to fair value and, vice versa, overpriced stocks gain a larger capitalisation.
In other words, a cap-weighting scheme leads to a suboptimal port-
folio strategy because portfolio weights are driven by market prices; as
such, more weights are allocated to overvalued stocks and less weight
to undervalued stocks. Therefore, these temporary shocks, called ‘noise’,
can obscure the real value of securities and lead to an incorrect valuation,
potentially for many years. In the academic literature, the phenomenon
of price distortions has long been debated. Some studies have verified
that the most popular stocks or investment topics, in a given period, are
those that have shown the best past performance and, with high proba-
bility, are those with the highest valuations compared to their historical
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 17

average. This phenomenon can also be observed at an institutional level

where portfolio managers, motivated by constant comparison with other
managers (specialising in the same market segment), and by objectives
linked to relative performance with respect to the market index adopted,
can tend towards imitative behaviour in investment choices, also known
as herding.
As already shown, focusing on the Internet bubble, the homogeneity
in the preferences of the economic operators inevitably gives rise to the
effect of provoking excesses of optimism or pessimism, due to the concen-
tration of investments and disinvestments on the same market topic and,
therefore, on the same securities. The result is an upward spiral of the
market valuations of these assets, which increases their weight within
the market indices. As a result, overvalued stocks outweigh undervalued
stocks, fuelling the bias. For these reasons, an increasing number of alter-
native market index construction methodologies have been promoted, in
order to build more efficient portfolios, in terms also of a higher level of
adherence of the market portfolio to the real economy, as well as greater
diversification and a better risk-return profile.
Among these, Arnott, Hsu, and Moore developed in 2005 a method-
ology known as fundamental indexation, suggesting the creation of
indices based on the accounting data of companies rather than on their
market value. These authors, recognised as pioneers of this methodology,
argue that it aimed at capturing the shares’ intrinsic value and overcoming
the problems arising from the ‘noise trading’ coming from irrational
investors. In particular, they design a stock market index weighted on the
basis of fundamentals, namely: revenues, book value, operating income,
and dividends. Accordingly, they built a Composite Index, which weighs
equally the average value of the four metrics. Their analysis is based on a
sample of 1,000 US stocks from 1962 to 2004. Results provide evidence
of an average annual excess return of 1.91% of the Composite Index over
the Standard and Poor’s 500 index associated with a similar risk profile.
Thereafter, other studies provide evidence of the fundamental indexation
superiority, focusing on different equity markets and time frames (see
Bolognesi and Pividori (2016) for a literature review).
This methodology has been the subject of numerous critiques. The first
claims that fundamental indexation is nothing more than a variant of a
‘value’ approach, already known in literature. The second critique is that
the outperformance of the fundamental indices is recorded only during
periods characterised by market anomalies such as financial bubbles, since
18 E. BOLOGNESI

at those times there are the most pronounced gaps between prices and
earnings. In the asset management industry, fundamental indexes have
been developed; the most famous is provided by Research Affiliates, a
company founded in 2002 by Arnott himself.
Moving to other alternative index design, Amenc et al. (2011) iden-
tify two sets of indexes: those based on representativeness and those
based on efficiency. In the first set, they recognise the cap-weighted and
fundamental-weighted methodologies. The cap-weighted methodology
uses the size in terms of market cap as a proxy for representativeness,
while the fundamental approach weights firms in terms of the sound-
ness of their balance sheets. Methodologies based on efficiency adopt a
strategy consistent with the principles of portfolio theory, suggesting the
search for securities characterised by the highest risk-return profile. Equal-
weighted, minimum volatility-weighted, and efficient-weighted indexes fall
into this category. In brief, equal-weighting attributes the same impor-
tance to each security, regardless of their characteristics. Therefore, they
follow the so-called naive diversification, i.e., the rule of 1 out of n, which
is independent of any components’ characteristics. On the one hand,
their performance is quite easy to calculate, being the arithmetic mean
of each component’s return. Moreover, if we consider a high number
of members, we benefit from a higher diversification because it prevents
larger caps to assume excessive weightings in the index. On the other
hand, managing an equal-weighted portfolio is more costly as a rebal-
ancing of all components is required at specific dates. In fact, over time,
the outperforming stocks gain an increasing weight within the index,
and vice versa for underperforming stocks. A periodic rebalancing of the
index is, therefore, necessary and consists of the partial sale of the stocks
that have outperformed and the purchase of the stocks that have under-
performed, in order to provide an equal weight. As a result, the index
rebalancing follows an implicit contrarian strategy, because winning stocks
are sold to buy the losers in the belief, based on the mean-reversion
hypothesis, that asset prices and historical returns gradually move towards
the long-term mean.
Proceeding with efficiency-based indices, the minimum volatility
methodology aims at minimising volatility and is based on the stocks’
volatilities and correlations. According to this approach, no estimate of
the expected returns of the components is necessary, therefore the focus
is not on the risk-return profile but solely on risk minimisation. Finally,
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 19

efficient-weighted indexes base their composition on the portfolio opti-

misation process. The objective, in this case, is to maximise the Sharpe
Ratio. In this case, the composition of the index is based on estimates of
expected return, volatility, and correlation between components.
The comparison between these five indexes allows for a greater under-
standing of their characteristics. Following Amenc et al. (2011) method-
ology, we have focused on the US equity market and, in particular, on the
following indexes: S&P500 Index (cap-weighted); S&P500 Equal (equal-
weighted); FTSE EDHEC-Risk Efficient Index (efficient-weighted);
MSCI Minimum Volatility Index (minimum volatility weighted); FTSE
RAFI 1000 Index (fundamental weighted). Each index is a total return,
meaning that dividends are considered in the performance. The analysis
period is twenty years, from January 2003 to January 2023. Figure 2.5
shows the 20-year pattern of the selected indexes. Overall, the equity
market has registered a positive return: the best performer has been
the efficient index followed by the equal-weighted index. The worst
performer has been the minimum volatility, followed by the cap-weighted.
Table 2.1 reports the main statistics. It is worth dwelling on some
of the results. The data highlight, over the selected period, an extra

Fig. 2.5 Performance of alternative US equity market indexes (2003–2023)

(Source Bloomberg data. Author computation)
20 E. BOLOGNESI

performance of almost all non-cap-weighted indexes. The exception is

the minimum volatility that shows a lower return with respect to the
S&P 500 Index as well as the overall lowest volatility. Moving to the risk-
adjusted measure, the efficient index presents the highest Sharpe Ratio
(0.62) while fundamental and cap-weighted show the lowest (0.56). The
beta parameter, calculated in relation to the S&P 500 Index, confirms the
defensive structure of the minimum volatility index. On the opposite side,
the most aggressive index is the equal weighted (beta equal to 1.1).
The risk-return profiles of the analysed indexes can be observed in
Fig. 2.6. The graph provides evidence that dominant portfolios are the
minimum volatility and the efficient portfolio. The cap-weighted shows
a medium volatility with respect to the others and it is dominated by
the efficient portfolio. In fact, if we had focused on the risk profile rela-
tive to the cap-weighted index, we could have obtained a better result by
combining the investment in the risk-free asset and the efficient portfolio.
Overall, we can conclude that the different index construction method-
ologies lead to significantly different results in terms of risk-return profile.
Over the time horizon analysed, the cap-weighted index shows an average
risk profile compared to the other indexes. The strength of this index is, as
mentioned several times, the absence of the need to periodically rebalance
its components. Instead, all the other indexes require a periodic rebal-
ancing and, therefore, a greater turnover which could weigh down the

Table 2.1 Return characteristics of alternative index construction methodolo-

gies (2003–2023)

Cap-weighted Fundamental Equal Efficient Min

weighted weighted weighted volatility
weighted

Return 9.88% 10.79% 11.49% 11.48% 9.08%

Standard 17.65% 19.19% 19.89% 18.47% 15.14%
deviation
Sharpe ratio 0.56 0.56 0.58 0.62 0.60
Minimum −20.02% −21.79% −20.67% −20.57% −19.34%
Maximum 11.46% 13.83% 14.44% 14.30% 12.24%
Beta (vs 1 1.06 1.1 1.02 0.81
CW)

Analyses are based on weekly returns. Returns and standard deviations are annualised. Beta is relative
to the cap-weighted index
Source Bloomberg data. Author computation
 2 THE IMPACT OF INDEX DESIGN ON ASSET MANAGEMENT 21

Fig. 2.6 Risk-return profile of alternative index construction methodologies

(2003–2023) (Analyses are based on weekly returns. Returns and standard
deviations are annualised. Source Bloomberg data. Author computation)

costs borne by the portfolio and, in the case of large portfolios, have an
impact on stock prices.

References
Amenc, N., Goltz, F., Martellini, L., & Ye, S. (2011). Improved beta? A
comparison of index-weighting schemes. EDHEC-Risk Institute.
Black, F. (1986). Noise. The Journal of Finance, 41(3), 528–543.
Bolognesi, E., & Pividori, M. (2016). Fundamental indexation in Europe: New
evidence. Journal of Financial Management, Markets and Institutions, 4(2),
103–128.
Clarke, R. G., Krase, S., & Statman, M. (1994). Tracking errors, regret, and
tactical asset allocation. Journal of Portfolio Management, 20(3), 16–24.
Hsu, J. C. (2006). Cap-weighted portfolios are sub-optimal portfolios. Journal
of Investment Management, 4(3), 1–10.
Lintner, J. (1965). The valuation of risky assets and the selection of risky
investments in stock portfolios and capital budgets. Review of Economics and
Statistics, 47 , 13–37.
Markowitz, H. M. (1952). Portfolio selection. Journal of Finance, 7 (1), 77–91.
22 E. BOLOGNESI

Roll, R. (1977). A critique of the asset pricing theory’s tests part I: On past
and potential testability of the theory. Journal of Financial Economics, 14(2),
129–176.
Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under
conditions of risk. Journal of Finance, 19(3), 425–442.
Siegel, J. (2006, June 14). The noisy market hypothesis. Wall Street Journal,
A14.
 CHAPTER 3

Pros and Cons of Active Management

Abstract This chapter focuses on the benefits and on the threats of active
management retracing the most significant contributions of the extensive
literature on this topic. We firstly focus on the definition of active manage-
ment, active risk and on the sources of alpha. Then we focus on the main
issues of interest concerning active management, namely: (1) the higher
costs and underperformance of active funds compared with respect to
index funds; (2) the attitude of herding which can generate market inef-
ficiencies; (3) the impact of the incentive schemes, short-terminism, and
incentive fees on returns; (4) the threats and opportunities of mispricing
and market anomalies.

Keywords Active management · Herding · Incentive schemes ·

Behavioural managers

We firstly can define active management as where there are active human
decisions being made about what the portfolio buys and what the port-
folio sells. The term active management refers to the implementation of
strategies which involve one or more deviations of the portfolio compo-
nents’ weights with respect to the benchmark. Here we rely on the
definition provided by Siegel (2003):

© The Author(s), under exclusive license to Springer Nature 23

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3_3
24 E. BOLOGNESI

Active management can be viewed as taking active bets against a bench-

mark. In other words, each security in the benchmark can be held at the
benchmark weight (which represents no active risk) or at a greater or lesser
weight (which represents some active risk). You can also take active risk by
holding securities that aren’t in the benchmark. Thus, any active portfolio
can be understood as an index fund plus a portfolio of long and short
positions relative to the benchmark. (p. 32)

In more detail, the active risk is measured by the excess returns volatility
of a managed portfolio compared to its benchmark (the active returns). It
is therefore natural to expect that a manager who takes no active positions
(who holds the benchmark portfolio) will have no active returns and no
active risk. In this regard, Grinold (1989) identifies the factors that influ-
ence the managers’ ability to generate extra returns. His model, known as
the Fundamental Law of Active Management, is based on three variables:
the ability of the manager (skill), the frequency with which investment
opportunities can be identified (breadth), and the added value of the
strategy adopted:

You can think of breadth as how often you play (number of times per
year) and skill as a measure of how well you play. The value added will
be measured in terms of annual return. A strategy’s value added will be
proportional to the strategy’s Sharpe ratio. (Grinold, 1989, p. 30)

Thus, active management means that the holding weights differ from
the benchmark portfolio in an attempt to produce excess risk-adjusted
returns, also known as alpha. The different holding weights reflect
management’s differing expectations of the overall market. In addition,
the manager must achieve excess returns systematically and with a reason-
able deviation from the benchmark. Only in these circumstances active
management is defined as efficient. Active managers make investment
decisions based on a variety of factors, including economic conditions,
company financials, and industry trends, and may buy or sell securities
frequently to try to capture market opportunities. Their approach may be
strictly algorithmic, entirely discretionary, or somewhere in between.
On the other side, passive management has been born as the simple
replication of a market index. Passive management is based on the Effi-
cient Market Hypothesis, meaning that asset managers are unable to
systematically outperform the benchmark or that any excess returns are
so low as not to justify the higher costs that active management involves
 3 PROS AND CONS OF ACTIVE MANAGEMENT 25

(costs of negotiation, analyses, research, etc.). Thus, passive managers do

not seek any other return than the market’s. Accordingly, they build port-
folios that reflect some benchmarks, without the need of generating excess
return. The turnover is usually low as are negotiation and management
fees. As a consequence, passive management is significantly cheaper than
active management.
The comparison between active and passive management has been at
the centre of an academic debate for a long time. Although the empirical
evidence acknowledges the difficulty of benchmark comparisons, the asset
management industry emphasises the following advantages that investors
may consider in investing in active funds: (i) Potential for outperformance:
active management may provide an opportunity for skilled managers to
identify undervalued or mispriced securities, anticipate market trends, and
generate higher returns than the broader market. (ii) Flexibility: active
management allows for more flexibility in portfolio management, as the
manager can adjust the portfolio holdings based on market conditions,
economic outlook, and other factors. This flexibility can potentially lead
to better risk management and higher returns. ( iii) Diversification: active
managers can provide investors with access to a wider range of investment
opportunities and asset classes that may not be available through passive
strategies. This can help investors to diversify their portfolios and poten-
tially improve risk-adjusted returns. (iv) Customisation: active managers
can tailor their investment strategies to meet the specific needs and objec-
tives of individual investors or clients. This customisation can provide
investors with greater control over their portfolios and help them to
achieve their unique investment goals.
Focusing on the main of these issues, Fuller (1998) identifies ‘infor-
mational advantages’ as one potential source of alpha in investment
management. He notes that managers who have access to unique or
proprietary information, or who are able to process information more
quickly or effectively than others, may be able to generate alpha. More
specifically, he focuses on possible management approaches which are
potentially capable of generating value:

1. Superior (private) information. This approach is based on the possi-

bility of producing better information than that which is publicly
available. This information is the result of analysis by the manager
based on the fundamentals of the companies being invested. Those
who use this style are defined as traditional (or fundamental )
26 E. BOLOGNESI

managers because they are characterised by their forecasting skills

regarding the earnings or profitability of listed companies.
2. Process information better. This means having quantitative fore-
casting models capable of processing information in a better way
than those produced by the average investors on the market. In
this case, managers who follow this approach are referred to as
quantitative.

Stating that an active investor has superior information compared to

other operators does not imply that the market forms expectations in a
distorted way. Instead, it is understood that the investments are based on
private information that the market does not possess and therefore that it
is unable to process, either correctly or distortedly. Similarly, if the model
the market uses to process information is not the most efficient, then it
is possible that the expectations embedded in the prices are not biased,
but simply not as accurate as those that could be generated by a better
model. The criticism that Fuller poses to these two methodologies can be
summarised in a simple question: what is the probability that an individual
investor (even a professional one) is able to gather superior information
or to develop a better model than the market when there are many other
subjects who try to do the same? The answer provided by Fuller is a third
management approach, based on the search for market anomalies caused
by behavioural mistakes:

3. Behavioural Biases . This approach is based on the irrationality in

the investment choices of economic agents which is reflected in
the market prices. Portfolio managers, therefore, concentrate on the
search for shares that are not fairly priced as a consequence of the
cognitive biases of market participants. Thus, behavioural managers
try to identify mispriced securities caused by behavioural distortions.
Among these, the most common is attributable to the presence of
professional investors who do not operate in compliance with tradi-
tional finance models and are affected by heuristics (such as loss
aversion). These behaviours induce managers to fall into mental
mistakes in a systematic way.

The generation of extra returns is linked to the alignment of investors’

and portfolio managers’ interests. As regards the active risks, several
 3 PROS AND CONS OF ACTIVE MANAGEMENT 27

constraints are set by the risk management in terms of deviation of the

managed portfolio from the benchmark. The primary objective of the risk
manager is to keep a level of risk assumed by managers in line with the
degree of risk that the shareholders of the asset management company
deem ‘desirable’. The metric commonly used to assess the intensity of
active bets is the tracking error volatility. It is calculated as the stan-
dard deviation of the daily or weekly extra returns of the portfolio on
its benchmark. It follows that the greater the tracking error volatility, the
higher the active risk, and, consequently, the intensity of active manage-
ment. The measure commonly used to define active management is the
information ratio defined as the ratio between the average excess returns
of the portfolio and the tracking error volatility. The information ratio
allows testing whether a portfolio managed by a fund provides a return
significantly larger than the benchmark. Since the benchmark portfolio
is supposedly efficient, the information ratio is useful in evaluating the
fund manager’s skills; the greater, the better the manager’s ability to select
profitable investment opportunities.

Main Issues in Active Management

Higher Costs and Underperformance
As already mentioned, active management is characterised by higher fees
and expenses than passive management strategies, such as index investing.
These higher costs can eat into investment returns and make it more
difficult to achieve long-term investment goals.
There is a vast literature that focuses on the performance recorded by
active managers. Most of these studies highlight the poor results that can
arise from an active management approach (‘act of man’) compared to
both market indices (‘act of God’) and passively managed funds. Focusing
on the most cited literature on active returns and performance persis-
tence, we can go back to the late 60s, when the first works on this subject
were published. To sum up the main evidence, we firstly recall Jensen
(1968) arguing that mutual funds do not outperform the market on a
risk-adjusted basis. Fama (1970) focuses on the efficient market hypoth-
esis (EMH), which posits that markets are generally efficient and that it
is difficult for investors to consistently outperform the market. Malkiel
(1973) claims that markets are generally efficient, and that it is difficult
for active managers to consistently outperform the market. Sharpe (1991)
28 E. BOLOGNESI

demonstrates that, in the aggregate, the managers of mutual funds do not

record higher returns than the benchmark. The reason behind this state-
ment lies in the fact that active management, in reality, is nothing more
than a ‘zero-sum game’. Carhart (1997) finds that past performance is
a good predictor of future performance, but only for a small subset of
funds. Moreover, outperformance is largely due to luck rather than skill.
Some evidence shows that the generalised underperformance recorded
by active funds is justified by the presence of transaction costs which
affect exclusively the performance of the managed portfolios. In other
words, the difficulty encountered when there is competition between a
fund and a market index can be attributed to the characteristic of the
benchmark which represents a ‘paper portfolio’ (Frino & Gallaher, 2001).
More evidence has been provided about the limited persistence over time
of the outperformance of active funds. This means that it is rare to find a
manager that can claim consistency in alpha generation (Davis, 2001).
Cremers and Petajisto (2009) introduced the concept of ‘active share’,
which measures the degree to which a portfolio deviates from its bench-
mark index, and have found that funds with high active share outperform
their benchmarks. Fama and French (2010) examined the relative impor-
tance of skill and luck in mutual fund performance and found that most of
the variation in returns can be attributed to luck rather than skill. Pastor
and Stambaugh (2012) examined the performance of mutual funds as
they grow in size. They found that, as funds become larger, their perfor-
mance tends to decline. Dyck et al. (2013) examined the performance of
active mutual funds in 32 countries over a 15-year period. The authors
found that active management tends to underperform passive manage-
ment in most countries, but that there are some countries (such as Japan
and the United Kingdom) where active management has been more
successful.
To sum up, the percentage of active managers who beat their bench-
mark varies from year to year, but research has consistently shown that a
minority of active managers outperform their respective benchmarks over
the long term.
Recent statistics provided by the industry confirm these results.
According to the S&P Dow Jones Indices Research (2021), which tracks
the performance of actively managed mutual funds in the United States,
the percentage of active funds that outperformed their respective bench-
marks in 2020 ranged from 9.83 to 39.41%, depending on the asset class
and time period analysed. Over longer time periods, the percentage of
 3 PROS AND CONS OF ACTIVE MANAGEMENT 29

active funds that outperform their benchmarks tends to decrease. The

latest report, published in June 2021, found that over a 1-year period,
50.8% of large-cap funds, 57.5% of mid-cap funds, and 72.7% of small-
cap funds underperformed their benchmarks. Over a 5-year period, the
figures were even worse, with 81.8% of large-cap funds, 88.6% of mid-cap
funds, and 94.6% of small-cap funds underperforming their benchmarks.
Similarly, the ‘Active/Passive Barometer’ provided by Morningstar found
that only 25% of actively managed funds in the United States beat their
respective category average over the 10-year period ending in December
2020.
This evidence highlights the difficulty of active management in creating
value for the subscriber. Here it is necessary to dwell also on the oper-
ational flexibility granted to managers. An indispensable requirement
for achieving extra returns with respect to the benchmark is, obvi-
ously, the manager’s ability to implement active bets on the portfolio he
manages. However, the operational flexibility of the manager is frequently
constrained by the risk management within certain risk parameters aimed
at safeguarding the managed portfolio. In other words, risk budgets
are generally set by risk managers in relation to the benchmark. The
manager’s freedom of action is therefore limited in order to avoid devia-
tions that are too extreme and which could compromise the performance
of the managed portfolio and, therefore, the reputation of the asset
management company.

Herding Behaviour
One of the major threats to active managers is ‘herding’. Herding refers to
the behaviour of investors or traders who follow the actions of their peers,
rather than making decisions based on their own independent analysis and
information. This behaviour can result in a group of investors making
similar investment decisions, leading to increased buying or selling pres-
sure and potentially causing market inefficiencies. Herding behaviour can
be driven by a number of factors, such as a desire to conform to social
norms, a fear of missing out on potential profits, and a perception of safety
in numbers. In some cases, herding can be rational and driven by a desire
to benefit from the collective wisdom of the group. However, herding can
also be irrational and lead to market bubbles and crashes, where investors
all follow the same strategy without regard to fundamental factors.
30 E. BOLOGNESI

The most theoretical research focuses on the rational motivations that

can push asset managers towards the same investment choices. More
specifically, the incentive of a fund manager to herd can be explained by
several issues. The first is a reputational risk. In particular, the trigger for
herding can be attributed to the willingness of asset managers to preserve
or improve their reputation. Scharfstein and Stain (1990) suggest that
when investment managers make unconventional investment decisions
and deviate from the consensus, they may face negative feedback from
their clients or peers if those decisions do not work out. As a result, invest-
ment managers may feel pressure to conform to the consensus and avoid
deviating too far from the herd:

A basic tenet of classical economic theory is that investment decisions

reflect agents’ rationally formed expectations; decisions are made using all
available information in an efficient manner. A contrasting view is that
investment is also driven by group psychology, which weakens the link
between information and market outcomes. (p. 465)

This form of group psychology, in many cases, generates the amplification

of exogenous shocks on the markets. Lakonishok et al. (1992) found that
mutual fund managers tend to overweight stocks that are widely held by
other mutual funds, leading to a positive correlation between the perfor-
mance of individual mutual funds. Bikhchandani et al. (1992) propose
that herding behaviour can be driven by information cascades, where
investors update their beliefs about the value of an investment based on
the actions of others, rather than on their own information. However,
they also note that information cascades can be inefficient, in that they
can cause investors to ignore their own private information and to follow
the actions of others without regard to fundamental factors. Devenow
and Welch (1996) propose that herding behaviour can be rational or irra-
tional depending on the circumstances. They suggest that herding can
be rational in situations where investors have limited information and are
uncertain about the value of an investment. In these situations, investors
may be more likely to follow the actions of others as a way of reducing
their uncertainty.
The empirical literature on herding is mainly based on the impact of
herding on financial markets. One of the cornerstones of these studies
is certainly the work of Grinblatt et al. (1995) focused on the analysis
of the performance of a sample of 155 US mutual funds, in the time
 3 PROS AND CONS OF ACTIVE MANAGEMENT 31

frame 1975–1984. The authors show the asset managers’ attitude to

the evaluation of securities on the basis of their past returns (positive-
feedback trading). Their results reveal the managers’ tendency to buy and
sell the same securities at the same time with a frequency that cannot be
attributed to pure chance. Froot et al (1992) show that investors tend to
follow the actions of their peers, and that this behaviour is more prevalent
during periods of high market uncertainty. Moreover, the study found
that herding behaviour can have a significant impact on stock returns.
Specifically, the authors found that stocks with high levels of herding tend
to have higher volatility and lower returns. They argue that the short-
term time horizon causes inefficiencies in financial markets. In particular,
traditional models that assume long-term investment choices consider the
presence of informational externalities as a negative factor. Conversely,
in the short run, investors view these externalities as opportunities to be
seized. They are thus led to base their decisions on this type of infor-
mation rather than on the fundamental values of the observed assets.
To sum up, ‘speculators herd: they acquire “too much” of some types of
information and “too little” of others ’. Falkenstein (1996) focuses on
the common attitude of institutional investors towards particular cate-
gories of securities. In particular, the composition of US mutual funds
suggests managers’ aversion towards those securities is characterised by a
low degree of liquidity (such as, for example, small-cap stocks). At the
same time, managers favour stocks about which they have more informa-
tion (even if of a public nature) and which boast the longest historical
series. Avery and Chevalier (1999) conducted a study on mutual fund
herding behaviour and found that mutual fund managers tend to herd
together and follow the same investment strategies, particularly in periods
of high market uncertainty. They suggest that herding behaviour can
be influenced by the incentives facing mutual fund managers, such as
performance-based fees and career concerns. Moreover, they show that
more experienced fund managers have less incentive to imitate other
managers. In this regard, the literature shows that the homogeneity in
the investors’ preferences can cause an excess of optimism or pessimism
originating from the concentration of investment strategies on the same
securities. For example, this phenomenon has been analysed by Sharma
et al. (2006) focusing on the investment choices of managers related to
Internet stocks before 2000. The study demonstrates a herding attitude of
increasing intensity during the bullish phase that characterised the interna-
tional stock markets. Moreover, they suggest that this herding behaviour
32 E. BOLOGNESI

can lead to market inefficiencies, as investors may overreact to news or

market developments and drive asset prices away from their fundamental
values.
Herding behaviour is an example of a behavioural finance
phenomenon, where investors make decisions based on the actions of
others rather than their own independent analysis and information.
Menkhoff et al. (2006) argue that herding behaviour in financial markets
can be explained by a combination of rational and behavioural factors.
They suggest that rational factors such as information asymmetry, uncer-
tainty, and risk aversion can lead to herd behaviour in financial markets.
Additionally, they argue that behavioural factors such as social influ-
ence, conformity, and cognitive biases also play a significant role in herd
behaviour. They also note that cognitive biases such as overconfidence,
anchoring, and confirmation bias can lead to investors ignoring their own
analysis and following the crowd.

Incentive Schemes and Short-Terminism

. Incentive schemes are generally linked to the performance (sometimes
risk adjusted) of the portfolio compared to its benchmark. In some cases,
an additional target is set in terms of comparison with other funds of
the same category/asset class. This dual target can significantly influence
investment decisions inducing managers to get closer to other funds’ allo-
cations and, thus, generating homogeneous behaviour. In other words,
the attention paid to the performance of peer funds can probably fuel the
phenomenon of herding among fund managers of the same asset class.
Usually, portfolio managers are incentivised based on short-term
performance metrics, such as quarterly or annual returns. This factor may
also encourage herding behaviour, as managers may be more likely to
follow the crowd in order to achieve short-term gains. From a psycholog-
ical point of view, the moment in which the performance of the managed
portfolio is recorded for the purpose of calculating the annual bonus is
certainly relevant for a manager. This moment commonly coincides with
the end of the year. The time horizon is an important element in portfolio
management because it can cause distortions in the investment decisions
of the managers by influencing their behaviour. For example, approaching
maturity could change the manager’s willingness to take risks. Another
 3 PROS AND CONS OF ACTIVE MANAGEMENT 33

possible effect deriving from the approaching end of the year could mani-
fest itself in the difficulty of implementing management strategies which
require a long time horizon to be able to appreciate the effects.
Academic literature focuses on this issue. Froot et al. (1992) argue that
short-term investment horizons can lead to suboptimal investment deci-
sions and potentially harm long-term returns. In their study, they found
that mutual fund managers with shorter investment horizons tended to
trade more frequently and incur higher transaction costs, which led to
lower net returns. They also found that managers with longer investment
horizons tended to hold more concentrated portfolios and take more
risks, which led to higher returns. They argue that short-term invest-
ment horizons can create a ‘myopic’ focus on short-term performance,
which can lead to inefficient trading and suboptimal portfolio construc-
tion. They suggest that longer investment horizons can provide a more
rational and disciplined approach to investing, allowing managers to take
advantage of market inefficiencies and generate higher returns over the
long term.
Chevalier and Ellison (1997) analyse the effects of incentive schemes
(affected by the end-of-year time horizon) on the risk appetite of the
manager. Their study demonstrates the greatest exposure to risk in
conjunction with the last quarter of the year and this effect is amplified if
we refer to the ‘younger’ funds. In detail:

In line with popular wisdom, young funds appear to have an incentive late
in the year to gamble and try to catch the market if they are a few points
behind; they may also have an inventive to play it safe and act more like
an index fund if they are ahead of the market. (p. 1170)

Baker (1998), through a survey involving sixty-four English fund

managers, analyses the effects of performance monitoring on the
behaviour of the manager. In particular, the author focuses on the risk
attitude of the manager, on the reward system, and on the time horizon
of investment decisions. Observing the implications of the frequency of
monitoring the recorded performance results reveals an inverse propor-
tionality with the time horizon of the manager’s strategies. Another
important negative relationship verified in this study is between the
average permanence of a security in the portfolio and the percentage of
the bonus linked to the relative performance of the managed product.
The resulting effect is the presence of factors which concentrate the
34 E. BOLOGNESI

manager on short-termism and modifying the behaviour. Concretely, this

translates into holding periods of the positions held in the portfolios
that are lower than the optimal ones, with particular reference to equity
investments.
Still focusing on incentive schemes, as far as returns are concerned,
maximising the fund’s return coincides with maximising the manager’s
remuneration. The mechanism most commonly used to achieve this goal
is represented by incentive fees applied to managed portfolios. These fees
are paid to the management company in case of the fund outperformance.
Elton et al. (2003) analyse this issue, defining this type of fees as follows:

An incentive fee is a reward structure that makes management compen-

sation a function of investment performance relative to some benchmark.
(…) There are a number of reasons why incentive fees are considered desir-
able. Perhaps the most often cited is that incentive fees align manager
interest with investor interests. Both groups do better when investment
does better. (p. 779)

The authors focus on a set of US funds charging incentive fees to verify

the effects they generate on managers’ behaviour. Their results confirm
the literature showing a greater convexity in the structure of the incentives
to managers in the presence of incentive fees. In other words, results show
a higher tracking error that characterises the funds that apply incentive
fees. Furthermore, the risk exposure exhibited by these funds is magni-
fied in the time window following a period of disappointing performance.
In line with these results, Massa and Patgiri (2008) find that incentive
mechanisms induce managers to take on greater risks while reducing the
probability of the fund’s survival. The reason for the outperformance
can be attributed both to lower fixed management fees (compensated
by incentive fees) and to higher selection skills of managers (attributable
to the fact that the best managers are attracted by companies able to
offer more competitive incentive schemes). As a result, incentive fees are
a desirable feature for fund subscribers.
Finally, several other studies have examined the impact of incentive
schemes on active management. Here, it is worth mentioning Brown et al.
(1996) argue that when the compensation is linked to relative perfor-
mance, fund managers likely to end up as ‘losers’ will manipulate fund
risk differently than those managing portfolios likely to be ‘winners’.
The authors focus on the performance of 334 growth-oriented mutual
 3 PROS AND CONS OF ACTIVE MANAGEMENT 35

funds during 1976 to 1991 and demonstrate that mid-year losers tend to
increase fund volatility in the latter part of an annual assessment period
to a greater extent than mid-year winners. Furthermore, they show that
this effect became stronger as industry growth and investor awareness of
fund performance increased over time.

Mispricing, Market Anomalies, and Behavioural Managers

Behavioural finance contrasts with traditional economic models as it
questions certain simplifying assumptions concerning the behaviour of
economic agents. With reference to financial markets, behavioural finance
considers how investors form their expectations about the future, and
how these forecasts are incorporated into prices. The heuristics of individ-
uals widely demonstrated in the literature (representativeness, availability,
anchoring) and the biases to which investors are subject (overconfidence,
excessive optimism, illusion of control) have the effect of influencing both
operators’ expectations and market prices, generating market anomalies.
Considering the vast literature on behavioural finance, we focus on the
contributions that first highlighted the errors in the investment choices
of market operators. For example, investors tend to sell ‘winning’ stocks
too early and keep stocks that have exhibited a negative trend in their
portfolio for too long (Shefrin & Statman, 1985), or excessive turnover
of institutional portfolios (Trueman, 1988). Another habit that emerges
from the literature is the preference of investors towards the purchase of
securities that have distinguished themselves as winners in the past and
the sale of the so-called losers (Hirshleifer et al., 1994), thus defining
a behavioural attitude, in the medium-term long term, to be positive-
feedback traders (De Long et al., 1990).
These distortions in investment choices are often interpreted as the
product of some typical non-rational attitudes of economic operators. For
example, excessive confidence in one’s predictive abilities leads to under-
estimating the variability of events and therefore it is reflected in the risk
appetite. Odean (1999) demonstrates how overconfidence is the cause of
the excessive operations of some traders, which also result in high transac-
tion costs such as to compromise the overall performance of the portfolio.
Still in the literature, the tendency towards conservatism (Edwards, 1968)
leads the investor to select, among the available information, those that
confirm his or her hypotheses, ignoring the elements that call them
36 E. BOLOGNESI

into question. The resulting effect is anchoring to pre-established posi-

tions, with a consequent adverse selection of one’s investments. In fact,
investors, in making a judgment, are anchored to certain values that are
impressed on their minds and do not deviate adequately from them. For
example, Shefrin (2000), observing the work of financial analysts, notes
that they start from an initial hypothesis in evaluating a company to
which, however, they remain mentally linked even when processing new
information.
On the one hand, portfolio managers, like all investors, can be subject
to a range of behavioural biases, such as confirmation bias, overconfi-
dence, and loss aversion. These biases can lead to herding behaviour
and an over-reliance on consensus views. On the other hand, portfolio
managers may concentrate on the search for shares that are not fairly
priced as a consequence of the cognitive biases of market participants.
Behavioural managers are investment managers who focus on identifying
and exploiting behavioural biases and irrationalities in financial markets.
They may use techniques such as sentiment analysis, social media moni-
toring, and quantitative analysis of investor behaviour in order to make
investment decisions.
Some proponents of behavioural finance argue that incorporating a
behavioural perspective into investment management can lead to better
decision-making and improved returns. However, others argue that it is
difficult to consistently generate alpha through behavioural strategies, and
that these approaches may be subject to their own biases and limitations.

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 CHAPTER 4

Searching for Market Drivers: Factor

Investing

Abstract Factor investing is designed to select securities based on

different market drivers among which, the first that have been identi-
fied from the academic literature are size, value, and momentum. Factor
research has the objective of generating risk and return profiles that differ
from traditional models, focusing on different market drivers compat-
ible with investor expectations. This investment style can be considered
somewhere between active management and passive management. Active
because the research is that of active returns with respect to the market
portfolio, passive because it is based on defined and transparent rules.
In this chapter, we first focus on the origins of factors through the
academic literature. Secondly, we move to the asset manager’s perspec-
tive describing the various facets of factor investing in asset management.
Finally, we focus on indexes aimed to describe each factor.

Keywords Factor investing · Smart beta · Fama and French three-factor

model · Factor indexing

Factor investing is an investment approach that involves selecting stocks

based on their exposure to specific factors or characteristics, rather than
simply buying a diversified portfolio of stocks. Factors are persistent and
pervasive drivers of return that have been identified in academic research.

© The Author(s), under exclusive license to Springer Nature 39

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3_4
40 E. BOLOGNESI

The basic idea behind factor investing is to identify securities that exhibit
strong exposure to a particular factor and to construct a portfolio that is
overweight in those securities. In particular, factor investors use quanti-
tative techniques to identify factors that are expected to generate excess
returns, but do not rely on individual security selection or market timing
to achieve these returns. Instead, they aim to capture the systematic and
persistent returns associated with certain factors over time.
From the asset manager’s perspective, factor investing is a sort of
middle ground between passive and active management. On one hand,
factor investing involves a systematic approach to portfolio construction
that is based on a set of rules or criteria, rather than on the subjec-
tive opinions of portfolio managers. This approach is similar to passive
management, where investments are made to track an index or bench-
mark, without the need for active decision-making. On the other hand,
factor investing aims to generate excess returns by selecting securities that
exhibit certain characteristics or factors. This approach is similar to active
management, where portfolio managers aim to outperform the market by
making active decisions on which securities to buy and sell.

The Theory Behind Factors

A factor is any characteristic that can explain the risk and return perfor-
mance of an asset. Here it is worthwhile to recall the theory behind active
portfolio management and then address those factors that are used in
building up factor portfolios and indexes. As aforementioned, active port-
folio managers have, for several decades, debated the efficiency market
hypothesis. In this regard, the CAPM asserts that stock returns can be
explained by just one factor, which is the market portfolio. However,
market beta alone is not capable of explaining the overall return of a stock.
Hence, academics claim that the CAPM is based on several unrealistic
assumptions1 that prevent it from being the ideal equilibrium model in

1 Assumptions of the CAPM model: (i) all investors take a position on the efficient
frontier where all investments are maximising utility and since investors are risk averse
and utility maximising, they focus only on their return (mean) and the related risk (vari-
ance). The exact location on the efficient frontier which investors select for their portfolio
will depend on their utility function and the trade-off between risk and return; (ii)
investors can borrow or lend any funds at the risk-free rate of return; (iii) all investors
have homogenous expectations, thus they make the same estimate regarding the expected
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 41

asset pricing. Considering these anomalies, Ross and Roll (1984) devel-
oped the Arbitrage Pricing Theory (APT), which is based on the idea
that assets returns are not merely generated by one factor but, instead,
by a set of factors able to capture broad risks across asset classes. Initially,
these factors were sought among macroeconomic variables, such as gross
domestic production (GDP), interest and exchange rates, oil prices, etc.
Later, the focus shifted towards the so-called style factors, such as firms’
size and other fundamental values. Two of the advantages of the APT
model are that it does not need the strong assumptions of the CAPM
and that it goes beyond the market portfolio concept. At the same time,
however, the APT leaves open the problem of identifying the number and
nature of relevant factors. Even if it is rather intuitive that the number of
relevant factors should not be too high, the problem is the identification
of the factors to be considered.
Certainly, the most famous multi-factor model is the one proposed by
Eugene Fama and Kenneth French, published in the Journal of Finan-
cial Economics in 1993, based on three factors. In particular, this model
focuses on the companies’ size and on their book-to-market ratio as
factors that can contribute to explaining stock returns. In particular, they
built a three-factor model according to which the return of a single secu-
rity or portfolio is explained by: (i) the reference market for the security/
portfolio; (ii) the parameter size based on the stocks’ market cap; (iii)
the parameter value, based on the book-to-market ratio. To sum up, this
model adds to the beta coefficient of the CAPM two new risk indicators
based on the stocks’ fundamentals. Empirically, the regression analysis is
based on the following formula:
[ ]
ri − R f = α + βmkti · Rmkt − R f + βSMBi · SMB
+ βHMLi · HML + εi (4.1)

where ri is the portfolio return, R mkt is the market return, R f is the risk-
free rate, SMB (Small Minus Big) is the difference between the returns of
small caps and blue chips; HML (High Minus Low) is the difference in

return, variance and covariance of all investible risky assets; (iv) all investors hold invest-
ments for the same one-period of time; (v) investors are able to buy or sell portions
from their shares of any security or a portfolio they hold; (vi) there are no taxes or
transaction costs on purchasing or selling assets; (vii) there is no inflation or any change
in interest rates; (viii) capital markets are in equilibrium, and all investments are fairly
priced, consequently, investors can not affect prices.
42 E. BOLOGNESI

returns of stocks with high and low book-to-market ratio; βmkti , βSMBi ,
βHMLi is the sensitivity of the portfolio to the reference market, size, and
book-to-market factors.
The rationale behind this model is that larger companies are less
risky than the smaller ones and, consequently, may offer lower expected
returns. Conversely, the small caps generally present higher risk and,
therefore, investors require a higher premium to compensate for the addi-
tional risk. The ratio between book-to-market values also holds a high
explanatory power: high ratios (low Price-to-Book Value) characterise
stocks with low expected growth and, therefore, less risky, and vice versa,
securities that show a low ratio denote good growth opportunities and
high intangible assets which are reflected in the market value rather than
into the book value.
Following evolution of the Fama and French (FF) three-factor model
is the four-factor model, introduced by Carhart in 1997, through a
famous article published in the Journal of Finance. In this model, Carhart
adds an additional factor called momentum. This factor is based on the
results of Jegadeesh and Titman (1993) showing that the strategy of
buying stocks that have performed well and selling stocks that have
performed poorly generated significant positive returns over 3- to 12-
month holding periods. Thus, momentum is the tendency of stocks that
have outperformed to continue the outperformance in the future. Based
on these results, a new variable, Winner Minus Losers, has been added
to the model, computed as the difference between the returns of stocks
with a positive performance (the winners) and stocks with a negative
performance (the losers). Formally:
[ ]
ri − R f = α + βmkti · Rmkt − R f + βSMBi · SMB
+ βHMLi · HML + βWMLi · WML + εi (4.2)

More recently, in 2015, Fama and French adapted their model to

include five factors. Along with the original three factors, the new
model adds the concept that companies reporting higher future earnings
show higher returns in the stock market, a factor referred to as prof-
itability. In more detail, this factor is based on the operating profitability,
‘OP’, measured as the annual revenues minus the cost of goods sold,
interest expense, selling, and general and administrative expenses during
the previous fiscal year, divided by the end book value of equity. The
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 43

construction of the OP-ranked benchmark portfolios permits the compu-

tation of the Robust minus Weak (RMW) factor. Furthermore, the fifth
factor, referred to as investment, relates to the concept of internal invest-
ment and returns, suggesting that companies directing profit towards
major growth projects are likely to experience losses in the stock market.
The authors define the measure of asset growth, ‘INV’, as the change
in the book value of total assets from the beginning to the end of the
previous period, divided by the previous end book value of total assets.
After the construction of the INV-ranked benchmark portfolios, they
calculate the Conservative minus Aggressive (CMA) factor. Hence, the
model is reshaped as follows:
[ ]
ri − R f = α + βmkti · Rmkt − R f + βSMBi · SMB + βHMLi · HML
+ βRMWi · RMW + βCMAi · CMA + εi (4.3)

From the first FF three-factor model, multiple factors have been tested
and academic research in this direction is constant. The impact of these
factors in asset management has been significant as they represent what
we now call management styles.

Fama–French Three-Factor Model: An Application to Alternative

Weighting Schemes
An interesting implementation of the FF three-factor model is the analysis
of the characteristics of the different index construction methodologies
examined in Chapter 2. The statistics on portfolios’ risk and return
provided in Table 2.1 produces insights into how the indexes behave.
However, it is also interesting to analyse where the return properties come
from. The non-cap-weighted indexes may take on exposures to the addi-
tional risk factors, i.e., value and small-cap exposure. Following the FF
model (Eq. 4.1) the first step is to select suitable indexes to construct the
explanatory variables. Focusing on the US equity market, the analysis is
based on weekly returns of the following indexes: S&P 500 Index as the
market portfolio; S&P 100 Index as a basket of blue chip stocks; S&P
400 Mid Cap Index as a basket of mid-caps (the bottom 400 of the S&P
500 Index); S&P 500 Value Index as a basket of high book-to-market
stocks; and S&P 500 Growth Index as a basket of low book-to-market
stocks. The observation period is 2003–2023.
44 E. BOLOGNESI

Table 4.1 reports the results. The Alpha coefficients are not significant,
except in case of the Efficiency Index, suggesting an outperformance, not
explained by the explanatory factors, equal to 2.70% on a yearly basis.
Moreover, the beta coefficients (calculated against the S&P 500 Index)
are qualitatively similar to what was obtained in Table 2.1: our find-
ings confirm the low beta nature of the minimum volatility index (0.80),
whereas the other indexes present betas reasonably close to 1. Overall,
SMB beta coefficients, when statistically significant, are positive. Similarly,
the value/growth exposure indicates that the index components’ compo-
sitions tilt towards value stocks if compared to the S&P 500 index. In
fact, each of the HML beta coefficients is negative and statistically signif-
icant. These findings can appear counterintuitive in some cases and must
be examined in more depth.
As expected, the fundamental-weighted index shows the lowest HML
beta coefficient (−0.40) confirming that it is aimed at rewarding compa-
nies showing the best fundamentals. Thus, stocks characterised by higher
earnings yields are mechanically overweighted, whereas stocks with a
low earnings yield are underweighted. Similar evidence can be identi-
fied concerning the firms’ characteristics selected by the index method,
notably dividends, book value, and sales. Stocks with a high dividend
yield, high book-to-market ratio, and high sales-to-price ratio should
be overweighted compared with their capitalisation weight. As these are
typical ratios used in value strategies, it is not surprising to find a substan-
tial exposure to the value factor. Moreover, the SMB beta coefficient is

Table 4.1 Comparison between alternative weighting schemes

Fundamental Equal weighted Efficient Min

weighted weighted volatility
weighted

Alpha (Ann) 1.28 1.02 2.70** 2.43

Market 1.02*** 1.05*** 0.98*** 0.82***
exposure
HML (0.40)*** (0.21)*** (0.13)*** (0.13)***
SMB 0.09*** 0.23*** 0.20*** (0.05)**
R2 0.98 0.98 0.98 0.90

Analyses are based on weekly returns. Source Bloomberg Data. Author computation
*** , ** , * Indicate statistical significance at the 1 percent, 5 percent, and 10 percent levels, respectively
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 45

positive (0.12) meaning that the fundamental index presents a higher

weight on small caps compared to the cap weighted.
Also, in the case of the equal-weighted index we find a positive SMB
beta (0.34) and a negative HML beta coefficient (−0.20). This latter
result is quite surprising because the construction methodology is neutral
and should be free of any value or growth bias. In fact, since no informa-
tion whatsoever on valuation influences the determination of its weights,
it is difficult to imagine that such an index would imply any choices
in terms of value or growth exposure. Thus, if we revert the analysis
and consider the equal-weighted index as a reference for value/growth
neutrality, the direct implication is that the bias is to be attributed to
the cap-weighted index. This evidence allows the argument that the cap-
weighted index presents a growth bias relative to the equal-weighted
index. Focusing on the SMB beta coefficient, it is not surprising that
its positive sign and its value are the highest of the indexes group. This
methodology imposes equal weights for which the mid-caps have the
same weight as the blue chips. It is therefore natural to expect that the
coefficient is the highest among indexes.
The efficient-weighted index is the only one presenting a statistically
significant alpha coefficient (2.26). This result confirms our previous find-
ings (see Table 2.1): the efficient-weighted index shows the highest shape
ratio of the group. The SMB beta coefficient is high and equal to 0.33
suggesting higher weights of mid-caps when compared with the S&P 500
Index. The HML beta coefficient is (−0.11) confirming the previously
mentioned evidence that the cap-weighted index presents a bias towards
value stocks.
Finally, the minimum volatility index does not present a statistically
significant SMB beta coefficient, meaning that the portfolio concentra-
tion in low beta stocks does not lead to any bias related to the stocks’ size.
Finally, also in this case the HML beta coefficient is negative, presenting
the same value of the efficient-weighted index (−0.11): this evidence
suggests that the two indexes are less exposed to the value bias.

Smart Beta and Factor Investing

The outlined academic results on the impact of different factors on
indexes returns have progressively declined in the asset management
industry with the launch of investment products based on strategies firstly
aimed at deviating from the traditional cap-weighting approach. As a
46 E. BOLOGNESI

consequence, the term Smart beta has gained popularity and gathers
all alternative forms of indexations departing from cap-weighting, that
aims to generate superior risk-adjusted returns, compared to traditional
indexation.
Smart beta was initially conceived as a response to two already
mentioned drawbacks of market-cap indexes. As summarised by Amenc
et al. (2011), the first drawback is that such portfolios typically provide
limited access to long-term rewarded risk factors such as size or value,
among others. The second problem with cap-weighting is the lack of
efficient diversification to the systematic risks due to excessive concen-
tration in the largest cap stocks. Some examples of Smart beta strategies
are, among others, the following: low volatility, value, fundamentally
weighted, high quality, momentum, risk parity, dividend yield, maximum
diversification, minimum variance, and equal weight. The primary objec-
tives for the use of Smart beta are risk reduction, return enhancement,
and improving diversification. Smart beta strategies are now widely avail-
able in ETFs and mutual funds, making factor strategies affordable and
accessible to every investor.
Similarly, Factor investing is an investment approach that involves
targeting specific drivers of return across asset classes. In other words,
it is an investment paradigm under which an investor decides how much
to allocate to various factors, as opposed to various securities or asset
classes. Its popularity has been growing since the turn of the millennium,
especially after the recognition in 2008 that multiple asset classes can
experience severe losses at the same time despite their apparent differences
(Martellini & Milhau, 2018).
As already mentioned, in the view of many academics, factor investing
lies between active and passive management. If we consider it from
the active point of view, this strategy helps managers to generate active
returns, thus creating alpha. If we turn to the passive management
perspective, factor investing is presented as rule-based and transparency
implementation. Thus, factor investing still tries to follow the EMH
presented by the Eugene Fama, but it is also based on the search for
long-term drivers of performance. Figure 4.1 provides a representation of
this idea.
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 47

Fig. 4.1 Factor investing as a middle ground between active and passive
investing (Source Author’s elaboration)

Factor Investing and the Asset Management Industry

Many institutional investors have approached factor investing over years.
The importance of factors in describing the investment strategies followed
by equity portfolios is quite tangible if we think of the famous Style Box
proposed for the first time in 1992 by Morningstar, a leading provider of
investment research and analysis. The Morningstar Style Box is illustrated
in Fig. 4.2: it is a simple 9-square grid that is used to classify mutual
funds based on two factors: size (market capitalisation) and value/growth
orientation. Each mutual fund is assigned a placement within the Style
Box based on its underlying holdings. For example, a mutual fund that
primarily invests in large-cap value stocks would be placed in the bottom-
left square of the Style Box. Its simplicity has been appreciated to such
an extent that the Style Box has become a fund categorisation standard
used by investors to quickly understand the investment style and compare
mutual funds.
Progressively, the world’s leading asset managers have devised factor-
based products in offering both mutual funds and ETFs. Among these,
we mention: BlackRock, Vanguard, State Street Global Advisors, Invesco,
Northern Trust Asset Management, JPMorgan Asset Management, and
Goldman Sachs Asset Management.
48 E. BOLOGNESI

Fig. 4.2 The

Morningstar’s style box
investing (Source
Morningstar website)

Focusing on BlackRock, one of the leaders in factor investing, the

launch of the first-factor fund dates back to 1971. The idea behind this
choice is that factors are broad and persistent drivers of return that are
critical to helping investors who are seeking a range of goals from gener-
ating returns and reducing risk to improving diversification. It is also
interesting how they communicate factor investing to potential investors,
defining factors as the foundation of investing: ‘Just as nutrients are the
foundations of the food we eat. Similarly, knowing the factors that drive
returns in your portfolio can help you to choose the right mix of assets
and strategies for your needs’. Moreover, the asset manager identifies two
main types of factors that drive returns. On the one hand, macro factors,
like the pace of economic growth and the rate of inflation can help to
explain returns across asset classes like equity or bond markets. On the
other hand, style factors can help explain returns within those asset classes.
Factors can help us build portfolios that better suit individual needs;
just as knowing the nutrients in your food can help your body perform.
Similarly, investors looking for downside protection in a volatile market
environment might add exposure to minimum volatility strategies to seek
reduced risk, while investors who are comfortable accepting increased risk
might look to more return-seeking strategies like momentum.
Vanguard defines factor-based funds as a form of actively managed
funds. They purposely tilt portfolios towards certain stock characteristics,
like recent momentum, higher quality, or lower stock prices to achieve
specific risk and return objectives. The asset manager argues that factor
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 49

funds may be appropriate for the experienced long-term investor who

wants to pursue specific factors but is looking for more transparency with
respect to in a traditional actively managed fund. Moreover, this kind of
investment is not expected to serve as a core investment, but a tool to tilt
a portion of the portfolio in an attempt to augment its performance.
Factor timing is extremely difficult, and strategies that attempt to do
so are ill-advised. So be sure you have the long-term patience needed to
stick with a factor-based investment strategy.
Finally, we rely on Invesco AM that believes that factor investing has
the potential to drive more precise investment and asset allocation deci-
sions in an attempt to optimise a truly diversified portfolio targeting a
specific risk/return objective. Moreover, the asset manager argues that
a factor-based investment approach seeks exposure to particular factors
rather than focusing on sectors, geographies, or investment styles.

Factor Indexing
The implementation and diffusion of this investment strategy has been
supported by the creation of factor indexes to be used as benchmarks.
For example, Morgan Stanley Global Investment (MSCI) Solutions, a
lead index provider, has been offering indexes based on multiple factors
since 2018. It is interesting to explore the factors selected by MSCI
for the construction of the related indexes, which are a selection based
both on evidence from academic research and on empirical evidence and
deriving from back-testing activities. The first set of factors provided has
been focused on volatility, dividend yield, quality, momentum, growth
and value bias, and firms’ size.
Starting from the most popular factors, the preference towards the
size factor, which translates into investment in medium–small sized secu-
rities, is based on empirical evidence demonstrating the persistence of
the outperformance obtained, over the long term, by small-cap stocks.
Size is categorised as a ‘pro-cyclical’ factor, meaning that it has tended to
benefit during periods of economic expansion. The size premium has been
evidenced by Fama and French (Eq. 4.1) and has been part of institutional
investing for decades. In the past few years, it has become a building block
of many factor-based indexes. On this issue, Banz (1981) examined the
relationship between the size of a company and its stock returns using data
from the New York Stock Exchange for the period 1936–1975. He found
evidence of a positive relationship between a company’s market value (i.e.,
50 E. BOLOGNESI

its size) and its average return, but this relationship was weaker for the
smallest and largest companies. This evidence established the size effect as
a significant empirical regularity in finance. He argued that the size effect
could not be explained by traditional asset pricing models, such as the
Capital Asset Pricing Model (CAPM), which assumes that higher returns
are associated with higher risk. MSCI has associated this factor with the
MSCI Equal-Weighted Indexes because it tends to overweight smaller
cap companies relative to the benchmark parent index. Index compo-
nents are weighted equally at each rebalance date, effectively removing
the influence of that constituent’s price (high or low) from the index.
The additional factor discovered by Fama and French supports
the value investing meaning that, over the long term, undervalued
stocks outperform more expensive stocks. Piotroski (2000) confirms this
idea, showing that companies with improving financial performance, as
measured by a combination of profitability, liquidity, and other funda-
mental factors, present higher returns than companies with deteriorating
financial performance. Value is captured through different market multi-
ples such as book-to-price and earnings yield. The foundation of value
investing is the notion that cheaply priced stocks outperform pricier stocks
in the long term. Value is categorised as a ‘pro-cyclical’ factor, meaning
it has tended to benefit during periods of economic expansion. Value has
several dimensions. For example, MSCI Enhanced Value Index applies
three valuation ratio descriptors on a sector relative basis: Forward price to
earnings (Fwd P/E); Enterprise value/operating cash flows (EV/CFO),
and Price-to-Book value (P/B). MSCI claims that the index aims to
address the pitfalls of value investing, among them ‘value traps meaning
stocks that appear cheap but which in fact do not appreciate’. Their
analysis shows that using forward earnings has helped provide protec-
tion against value traps, and that whole firm valuation measures, such as
enterprise value, have reduced concentration in highly leveraged compa-
nies, meaning those that have borrowed heavily. Many investors use this
approach in identifying assets that they expect the market to revalue. It
is worth mentioning that indices built according to the value style use
the same investment philosophy as indices built according to fundamental
indexation.
Following the results of Jegadeesh and Titman (1993) and the four-
factor model of Charart (see Eq. 4.2), the momentum factor refers to
the tendency of winning stocks to continue performing well in the near
term. In other words, it takes advantage of market trends and focuses
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 51

on stocks that have outperformed the market because they have greater
relative strength. Many studies since then have found the momentum
factor present across equity sectors, countries, and more broadly asset
classes. MSCI categorises the momentum factor as a ‘persistence’ factor,
i.e., it tends to benefit from continued trends in markets. The index
provider highlights that momentum is not well understood as other
factors, although various theories attempt to explain it. Some postulate
that it is compensation for bearing high risk; others believe it may be a
consequence of market inefficiencies produced by delayed price reactions
to firm-specific information.
The minimum volatility is a strategy that involves buying stocks based
on the estimate of their volatility and correlations with other stocks.
Minimum volatility is categorised as a ‘defensive’ factor, meaning that
it has tended to benefit during periods of economic contraction. As
discussed by MSCI, the key objective of this strategy is to capture regional
and global exposure to stocks with potentially less risk. Tactical investors
have used MSCI Minimum Volatility Indexes to reduce risk during
market downturns, while retaining exposure to equity. The minimum
volatility premium (MVP) refers to the excess returns that can be earned
by investing in low-volatility stocks. The idea is that stocks with lower
volatility should, on average, provide higher risk-adjusted returns than
more volatile stocks. The MVP is the minimum level of this excess return
that investors should expect to receive. One theory posits that investors
underpay for low-volatility stocks, viewing them as less rewarding, and
overpay for high-volatility stocks that are seen as long-shot opportu-
nities for higher returns. Moreover, investors can be overconfident in
their ability to forecast the future, and their opinions can differ more
for high-volatility stocks, which have less certain outcomes, leading to
higher volatility and lower returns. In terms of methodology, the main
approaches to implementing a minimum volatility strategy fall into two
groups: (1) simple rank and selection and (2) optimisation-based solu-
tions. A simple approach ranks the universe of stocks by their expected
volatility, selects a subset of the constituents from the universe, and then
applies a weighting method. These approaches generally ignore the corre-
lation between stock returns, which can have a significant impact on
the overall volatility strategy. While a simple rank and selection method
reflects the volatility of individual stocks, optimisation-based approaches
account for both volatility and correlation effects, i.e., the magnitude and
52 E. BOLOGNESI

the degree to which stocks move in tandem. However, a naive uncon-

strained minimum volatility strategy has its own set of challenges, such as
biases towards certain sectors and countries, unwanted factor exposures,
and potentially high turnover at rebalancing. Well-designed optimisations
with carefully constructed constraints, however, may be able to neutralise
these shortcomings.
Another example of defensive strategy is the high dividend yield
strategy which gains exposure to companies that appear undervalued and
have demonstrated stable and increasing dividends. Index constituents of
the MSCI High Dividend Yield Indexes are selected not only on the
basis of the dividend yield, generally at least 30% higher than the average
dividend yield of the market, but also on fundamentals. Investors may
focus on the equity dividend income because they are seeking income
outside of the fixed income. Several theories seek to explain the supe-
rior performance of high dividend stocks. One notes that yield investors
have preferred dividend payouts in the present to uncertain capital gains
in the future. They have also tended to view dividend increases as a sign
of future profitability. Several studies show that dividend yields have been
strong indicators of earnings growth. Fama and French (1988) show that
high dividend yields are associated with high expected returns and that the
dividend yield is a strong predictor of future earnings growth. Arnott and
Asness (2003) analysed data from 1972 to 2001 and found that compa-
nies that increase their dividends tend to have higher earnings growth
in subsequent years. Moreover, Shiller (1981) and Campbell and Shiller
(1988) showed that dividends are a good indicator of future earnings
growth and that companies that pay high dividends tended to have more
stable earnings.
The quality factor is also a defensive factor because based on the funda-
mentals of companies, rewarding those with durable business models and
sustainable competitive advantages. For example, some measures used in
stock selection are return on equity (or ROE), leverage, and earnings
variability. This factor is based on Fama and French five-factor model (see
Eq. 4.3) presenting a relationship between stock returns and fundamen-
tals. From an operational point of view, the MSCI Quality Index employs
three fundamental variables to capture the quality factor: Return on equity
(which shows how effectively a company uses investments to generate
earnings growth); Debt to equity (a measure of company leverage); and
Earnings variability (how smooth earnings growth has been). Further-
more, MSCI argues that many active strategies have emphasised quality
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 53

growth as an important factor in their security selection and portfolio

construction. Focusing on academic literature, Novy-Marx (2012) exam-
ines the relationship between company profitability and stock returns.
He shows that companies with high gross profitability (defined as gross
profits to total assets) present higher returns than companies with low
gross profitability, even after controlling for traditional value and size
factors. He argues that gross profitability is a better measure of a compa-
ny’s economic profitability than earnings-based measures, such as return
on equity (ROE) or earnings before interest and taxes (EBIT). This
is because earnings-based measures can be affected by accounting deci-
sions, while gross profitability is based on a company’s ability to generate
revenue after accounting for the costs of goods sold. Fama and French
(2015) show that profitability is one of five key factors that explained
differences in stock returns. They defined profitability as operating income
before depreciation and amortisation scaled by book equity.
Finally, the attention towards factor investing is evidenced by the
growth both of assets under management towards specialised products in
this segment, and by the study of new factors, such as liquidity, based on
trading and turnover statistics of selected securities and growth, based on
the revenue and profit growth. Finally, the evolution of factor investing
is certainly a multi-factor investment allowing additional benefit from
diversification in investing on different factors.
To better understand the characteristics of these most popular factors,
we proceed with the analysis of the corresponding MSCI Indexes. In
order to exclude geographical and currency implications of the portfo-
lios’ composition, we focus on the US equity market. The indexes selected
are listed in Table 4.2. The cap-weighted portfolio is associated with the
MSCI US Index.

Factor Investing: A Back-Test Exercise

We analyse the risk-return profile of factor indexes over a 20-year period,
from 2003 to 2023. We rely on the MSCI Indexes described in Table 4.2.
We calculate returns and standard deviations on a weekly frequency using
Bloomberg. Results, on a yearly basis, are presented in Fig. 4.3. Looking
at the statistics of returns, it is important to underline that results can
change considerably depending on the time window considered. In this
analysis, the choice has been to extend the observation period as much as
possible, depending on the data availability.
54 E. BOLOGNESI

Table 4.2 Factors and indexes description

Factor MCSI index Description

Quality MCSI The Quality factor is aimed at capturing companies with

quality durable business models and sustainable competitive
index advantages
Yield MCSI high A yield investment strategy gains exposure to companies
dividend that appear undervalued and have demonstrated stable and
yield index increasing dividends
Growth MCSI The Growth factor captures company growth prospects
growth using historical earnings, sales and predicted earnings
index
Value MCSI value Value investing is premised on identifying stocks whose
index prices seem to understand their intrinsic value
Volatility MCSI A minimum volatility strategy involves buying stocks based
minimum on the estimate of their volatility and correlations with
volatility other stocks
index
Momentum MCSI The Momentum factor refers to the tendency of winning
momentum stocks to continue performing well in the near term
index
Size MCSI equal The Size factor capture the tendency of small-cap stocks
weight to outperform bigger companies over the long run
index

Source Author elaboration on MSCI data

Observing the chart, it is possible to draw the following considera-

tions: (i) Dominant portfolios, according to the mean–variance principle,
are the minimum volatility, the quality, and the momentum, whereas the
latter presents the highest risk. (ii) As expected, the most conservative
portfolio is minimum volatility, followed by quality and dividend yield.
(iii) The portfolio presenting the highest volatility is the small cap, but
its high level of risk is not rewarded by a high return if compared to other
portfolios. (iv) The worst portfolio, in terms of risk-return profile is the
value. Here it is interesting to note the remarkable difference between the
value and the quality portfolios because, ideally, they could be considered
quite similar. On the contrary, in this analysis, they show opposite char-
acteristics: in fact, the quality portfolio is dominant while the value is
dominated by all other portfolios. (v) Generally, growth and value styles
are considered to be opposites but, in this analysis, they present fairly
similar levels of risk. (vi) The cap-weighted portfolio is positioned in the
middle of all other portfolios in terms of both risk and return. Therefore,
 4 SEARCHING FOR MARKET DRIVERS: FACTOR INVESTING 55

Fig. 4.3 Factor indexes: Risk-return profile (Analyses are based on weekly
returns. Observing period: January 2003–January 2023. Source Bloomberg Data.
Author computation)

assuming that each portfolio is mainly composed of the same stocks (at
least, US stocks), but in different proportions, the cap-weighted portfolio
becomes a sort of point of reference, and that each strategy moves away
from it in a different measure and direction. (vii) The multifactor repre-
sents a synthesis of all the styles. It presents a risk profile similar to that
of the cap weighted but a significantly higher return.
To sum up, factor investing is designed to select securities based on
different market drivers and aims at achieving the following goals:

1. Improved Risk-Adjusted Returns: Factor investing aims to identify

securities that have higher expected returns than the overall market,
while also managing risk. By focusing on factors that are associ-
ated with higher returns, factor investing can potentially provide
better risk-adjusted returns than traditional market cap-weighted
approaches.
2. Diversification: Factor investing can provide diversification benefits
by investing in securities that are not necessarily correlated with
each other. By combining different factors, investors can potentially
reduce overall portfolio risk.
56 E. BOLOGNESI

3. Transparency: Factor investing typically involves a rules-based

approach, where securities are selected based on certain predefined
criteria. This can provide greater transparency than traditional active
management approaches, where investment decisions may be based
on subjective criteria.
4. Lower Costs: Factor investing can potentially be less expensive than
traditional active management approaches, as it typically involves
passive or semi-passive investment strategies that are implemented
through index funds or ETFs.
5. Flexibility: Factor investing can be tailored to individual investors’
needs and preferences. Investors can choose to invest in factors that
are aligned with their investment goals, risk tolerance, and other
factors.

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 CHAPTER 5

Hybrids Increasingly Blurring

Active/Passive Line

Abstract This chapter focuses on the exponential growth of passive

management and on the evolution of this industry. We first focus on
the birth of Index Funds and Exchange-Traded Funds, providing several
statistics on the dynamics of passive investing in the equity markets.
Therefore, we focus on the main developments of this sector and the
advance of hybrids that are erasing what was once a clear line between
active and passive management. As a consequence, active and passive
investment products are moving closer and closer, so much so that they
have begun to overlap: examples are Smart beta ETFs and Active ETFs.

Keywords Index funds · ETFs · Smart beta · Active ETFs · Active

Non-Transparent ETFs

As discussed in Chapter 4, active management is suffering several threats,

among which the most important from the investors’ perspective is the
overall underperformance of active funds. As already mentioned, this
result is supported by the Efficient Market Hypothesis (EMH) suggesting
that financial markets are ‘informationally efficient’, meaning that all avail-
able information about a security is already reflected in its current price.
According to EMH, it is impossible to consistently beat the market
through active management because all available information is already

© The Author(s), under exclusive license to Springer Nature 59

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3_5
60 E. BOLOGNESI

incorporated into the price, and any attempt to outperform the market
is based on luck rather than skill. The consequence is the difficulty for
active managers to consistently outperform the market, making passive
management a more attractive option for investors who believe in EMH.
By investing in a passive fund that tracks a market index, investors achieve
similar returns as the market pays lower fees than active funds.
In and around the 1960s, a confluence of factors (in particular the
advent of computers) allowed a small group of academics to verify how
money managers were performing versus the US stock market. One of
their findings was famously articulated by Burton Malkiel in his 1973
book, A Random Walk Down Wall Street, in which he argued that ‘a
blindfolded monkey throwing darts at the stock listings’ would do as well
as the pros. The author argues that stock prices are largely random and
unpredictable in the short term, and therefore, attempts to consistently
beat the market through active management are unlikely to succeed. This
means that trying to beat the market by identifying undervalued stocks
or predicting market trends is a fruitless effort, and that investors are
better off adopting a passive investment strategy, such as investing in
index funds or ETFs, that aims to match the performance of the overall
market or a particular market index (Malkiel, 2003, 2005). He also argues
that investors should focus on asset allocation and diversification rather
than stock picking, as spreading investments across different asset classes
and sectors can reduce risk and potentially improve long-term returns.
Furthermore, Malkiel emphasises the importance of keeping investment
costs low and avoiding market timing and other forms of speculation that
can lead to poor investment outcomes.
It is on these assumptions that the role of the market portfolio assumes
central importance in asset management and, therefore, the observation
and attention paid to market indices.

Index Portfolios and Exchange-Traded Funds

The search for market performance, as a more efficient and econom-
ical management strategy compared to the active one, has led to the
creation of funds specialising in replicating the composition of the bench-
marks. Therefore, index funds have inevitably become popular in financial
market, although they did not receive the full attention from investors
in the beginning. In fact, index funds had been around since the
1970s, they were initially only available to institutional investors and had
 5 HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE 61

high minimum investment requirements. The first retail index fund was
launched by Vanguard Group on 31 August 1976. The fund was called
the Vanguard 500 Index Fund and it tracked the performance of the S&P
500 Index, allowing individual investors to invest in a diversified portfolio
of stocks with low fees. This index fund has been a major milestone in the
development of passive investing and index funds, and it has since become
one of the largest and most popular index funds in the world.
The transition from Index Funds to Exchange-Traded Funds (ETFs)
occurred gradually over several years, starting in the 1990s. Like index
funds, ETFs seek to replicate the performance of a particular index, but it
is traded like an individual stock on an exchange. Thus, the main differ-
ence between index funds and ETFs is their greater flexibility: ETFs can
be traded throughout the day, allowing investors to buy and sell shares at
any time, while index funds can only be bought or sold at the end of the
trading day. ETFs also have lower expense ratios than most index funds,
making them an attractive option for investors looking to minimise costs.
The first ETF, known as the Toronto Index Participation Shares
(TIPS), was introduced on the Toronto Stock Exchange in 1990 with
the aim of tracking the Toronto 35 Index. However, the TIPS ETF was
short-lived and only traded for a few months before being delisted. The
first ETF to gain widespread popularity and become a major force in the
financial industry was the SPDR S&P 500 ETF, which was launched in
the United States in 1993 by State Street Global Advisors. Its nickname
‘Spider’ is derived from the fund’s ticker symbol, which is ‘SPY’.
Since then, the growth of passive management has been steady. In
order to better understand this phenomenon, especially in the equity
sector, it is useful to compare the evolution of Asset under Management
(AuM) between active funds and passively managed funds (index funds +
ETFs). Figure 5.1 shows the success of AuM under passive management
compared to those funds under active management, by late 2019. At the
end of 2022, passively managed funds exceeded actively managed funds
by more than 1.5 trillion. It should also be noted that in the entire obser-
vation period, the passively managed funds are approximately half index
funds and half ETFs.
Focusing in more depth on the ETFs industry, the multiplication of
ETFs occurred rapidly, first by offering the replication of all the main
world market indexes. Subsequently, the industry expanded towards the
replication of management strategies typical of active management. The
following statistics are aimed at tracing the evolution of this industry over
62 E. BOLOGNESI

Fig. 5.1 Active vs passive equity funds: AuM (Source Author’s elaboration on
Bloomberg data)

time. Focusing on the dynamic of the AuM, Fig. 5.2 shows the huge
growth of this industry. By late 2022, the total amount of AuM in ETFs
was nearly 6.5 trillion USD and mainly focused on the equity market.
The geographic focus of equity ETFs is mainly on the US stock market.
Figure 5.3 clearly shows this evidence and denotes the strong contri-
bution of the US asset managers in the evolution of this investment
tool.

Fig. 5.2 ETFs industry: AuM (Source Author’s elaboration on Bloomberg data)
 5 HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE 63

Fig. 5.3 Geographical focus of ETFs: AuM (Source Author’s elaboration on

Bloomberg data)

Other interesting statistics on the ETFs dynamic are related to the

stock’s size in the portfolios. As can be seen in Fig. 5.4, at the begin-
ning (1993) the focus was only on the main US index, which implied
investment exclusively in large caps. In 1995, the first funds specialised
in mid-caps were launched, while the interest in small caps dates back to
2000. By the end of 2022, small caps represent nearly 10% of the equity
market.

The Active–Passive Investment Line

If a decade ago the definitions of active and passive management were
clearly distinct, over time the line has progressively blurred. At the begin-
ning of the 2000s, the two sectors had clear objectives and the opposition
was between the search for active returns (alpha), through the leverage of
beta or stock picking skills, or the return of the market.
Gradually the two management philosophies have progressively
converged. Starting with active management, risk management
constraints have increasingly tied managers to benchmarks, making
active management subject almost exclusively to relative return versus the
market rather than absolute return oriented. Due to these constraints,
active managements have progressively moved closer to the so-called
semi-active managements. On the other hand, thanks to the success of
 64
E. BOLOGNESI

Fig. 5.4 Size focus of ETFs: AuM and percentage (Source Author’s elaboration on Bloomberg data)
 5 HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE 65

ETFs and the progress made by index providers in the creation of new
market indexes, passive management has progressively moved towards
the typical strategies of active management, such as those based on
sectors. This evolution of ETFs has been rapid and has had the effect of
increasing pressure on active funds.

Core-Satellite Strategy
A sort of compromise between active and passive management is semi-
active management. By following this strategy, the manager seeks to
achieve a return slightly higher than that of the benchmark by deciding on
some cautious and controlled deviations. Operationally, the most popular
approach is the core-satellite strategy.
As illustrated in Fig. 5.5, this strategy involves dividing the portfolio
into two parts: a ‘core’ part and a ‘satellite’ part. The core part of the
portfolio is typically invested in low cost, passively managed funds, such
as index funds or ETFs, that aim to track the broad market. The core
portion of the portfolio is designed to provide a stable, diversified foun-
dation of investments that capture the overall performance of the market.
The satellite part of the portfolio is invested in actively managed funds
that target specific investment strategies. The satellite part of the port-
folio is designed to provide an opportunity for alpha generation by taking
advantage of the inefficiencies in the market.
The overall goal of the core-satellite strategy is to achieve a balance
between cost-effective passive investing and active investing that seeks

ACTIVE MUTUAL FUND

Fig. 5.5 Core-satellite
strategy (Source
CORE
Author’s elaboration) PORTFOLIO

SATELLITE
PORTFOLIO

Market returns Active

returns
66 E. BOLOGNESI

to outperform the market. By using a combination of passive and active

investment strategies, the core-satellite approach aims to achieve the bene-
fits of both approaches, namely low-cost diversification and the potential
for alpha generation through active management.

Smart Beta ETFs

Smart beta ETFs are funds that follow rules-based investment strategies
that seek to capture specific factors or characteristics that are believed to
drive returns. As already mentioned in this chapter, a Smart beta approach
is based on factors such as size, value, momentum, high dividend yield,
etc. The purpose is to construct a portfolio of securities that are designed
to outperform the traditional market capitalisation-weighted indices.
Smart beta ETFs aim to provide investors with a better risk-return
profile than traditional passive ETFs while maintaining the benefits of
low cost and diversification. Smart beta investing combines the benefits
of passive investing and the advantages of active investing strategies. The
goal of Smart beta is to obtain alpha, lower risk, or increase diversification
at a cost lower than traditional active management and marginally higher
than straight index investing.
Figure 5.6, graph (a), presents the dynamics of the industry of Smart
beta ETFs in terms of AuM. The graphs also show the amount invested
in the specific factors. By the end of 2022, the AuM was nearly 1.3 tril-
lion USD. Graph (b) highlights more clearly the dynamic of the different
factors. It is interesting to notice that until 2002 the industry has mainly
focused on investment strategies of value and growth. Subsequently, size
and dividend yield have been introduced. Finally, since 2011 an increas-
ingly significant share of AuM has been positioned on products focused
on minimising volatility.
For a better understanding of the popularity of this investment tool,
it is interesting to dwell on another comparison, in particular between
Smart beta and sectoral ETFs. Even the latter, introduced in the early
2000s, aimed to move away from portfolios based on geographical allo-
cation in order to take advantage of different phases of the economic
cycle. For example, in phases of economic expansion, cyclical sectors are
favoured while in phases of slowdown, consumer staples, and healthcare
are preferred. Moreover, sectorial ETFs track, like traditional ETFs, cap-
weighted indexes. However, they are used for tactical portfolio allocation.
Figure 5.7 show the dynamics of the AuM: as can be seen, if in 2012 the
 5

1,600,000
100%
1,400,000
90%

1,200,000 80%

70%
1,000,000
60%
800,000
50%

600,000 40%

30%
400,000
20%
200,000
10%

- 0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Growth Value Dividend/Yield Size
Growth Value Dividend/Yield Size Low Volatility Multi Momentum Quality
Low Volatility Multi Momentum Quality

Fig. 5.6 Smart beta ETFs: AuM (Source Author’s elaboration on Bloomberg data)
HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE
67
68 E. BOLOGNESI

Fig. 5.7 Smart beta vs sectorial ETFs: AuM (Source Author’s elaboration on
Bloomberg data)

two types of ETF were similar in terms of interest from investors, ten years
later, the preference for strategies based on factors is double compared to
those based on sector allocation.

Active Exchange-Traded Funds

As widely described, ETFs have experienced unprecedented growth in
popularity and in size due to their simplicity and low cost. Their goal is
to invest in or replicate the performance of a basket of assets or index
through a ‘passive’ investment strategy, i.e., automatically buying and
selling based on the benchmark being tracked. The next step taken by
the industry has been the search for a hybrid approach able to keep the
advantages of the format of ETFs while outperforming benchmarks. In
2008, the US Securities and Exchange Commission (SEC) approved the
first actively managed ETF, the Bear Stearns Current Yield Fund. The
ETF was designed to provide investors with exposure to short term, high-
quality fixed income securities, with the aim of generating income and
preserving capital.
Active ETFs differ from traditional ETFs in that they are managed
by a portfolio manager or team of managers who make investment deci-
sions with the aim of outperforming the market. The portfolio holdings of
an active ETF can change more frequently than those of a passive ETF,
depending on the investment strategy being used. Thus, the portfolio
 5 HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE 69

manager has full discretion over the fund’s investments. As a result, active
ETFs tend to have higher fees than passive ETFs. Moreover, unlike Smart
beta ETFs, that follow a set of predetermined rules, active ETFs rely on
the subjective decisions of a portfolio manager. As a result, active ETFs
tend to have higher fees than Smart beta ETFs.
Active ETFs comprise a relatively small portion of the entire $5 trillion
ETF industry focused on equity. As shown in Fig. 5.8, as of December
2022, these funds contained about $215 billion, or nearly 4% of the ETF
equity market.
Finally, the most recent evolution of Exchange-Traded Funds is that
of Active Non-Transparent (ANT) ETFs . Unlike traditional ETFs, which
are required to disclose their holdings on a daily basis, ANT ETFs are
allowed to keep their holdings confidential, revealing them only period-
ically or under certain circumstances. This allows portfolio managers to
maintain their investment strategies without revealing their trades to the
market, which can help prevent front-running and other market impacts
that can result from daily disclosure. ANT ETFs were first approved by the
SEC in 2019. The SEC’s approval of these ETFs followed several years of
discussions and deliberations over how to structure and regulate actively
managed ETFs that did not fully disclose their holdings on a daily basis.
The first ANT ETFs were launched in the United States on May 2020 by
major asset managers.

250,000

200,000

150,000

100,000

50,000

0
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Fig. 5.8 Active ETFs: AuM (Source Author’s elaboration on Bloomberg data)
70 E. BOLOGNESI

Further Statistics
The active/passive investment line is increasingly blurred. As repeatedly
stated, active management has disappointed investors’ expectations with
poor statistics on performance and their persistence over time. The risk
management has progressively linked active management to the bench-
mark with a risk budget and monitoring of the tracking error volatility.
The result has been a shift towards semi-active management and active
bets limited to a small ‘satellite’ part of a portfolio that mainly mirrors the
benchmark. As a consequence, we are witnessing the exponential growth
of the passive management industry, first through index funds and then
through ETFs. The latter, transparent and low cost, have increasingly
evolved to offer investment strategies aimed at creating value by first blur-
ring the line between active and passive management through Smart beta
ETFs and then, crossing it through the recent Active ETFs. This process
is clearly visible from the observation of Fig. 5.9. Over the course of
10 years, active management was about 67% of equity investing. In 2022
the statistic reversed itself, reducing to 43%. Looking at these further
statistics, the advance of passive investing appears to be unstoppable.

Fig. 5.9 Active vs passive investing (Source Author’s elaboration on Bloomberg

data)
 5 HYBRIDS INCREASINGLY BLURRING ACTIVE/PASSIVE LINE 71

References
Malkiel, B. G. (1973). A random walk down Wall Street. Norton.
Malkiel, B. G. (2003). The efficient market hypothesis and its critics. Journal of
Economic Perspectives, 17 (1), 59–82.
Malkiel, B. G. (2005). Reflections on the efficient market hypothesis: 30 years
later. Financial Review, 40(1), 1–9.
 CHAPTER 6

The Need for a Change: Sustainable Finance

Abstract This chapter focuses on the birth and evolution of sustainable

finance. The main steps that have been taken in the last century in this
sector are retraced. Over time, in fact, the perspective of investors has
increasingly broadened towards assessments that go beyond the portfo-
lio’s risk and return profile and which include the principles of investment
ethics. We will first focus on the steps, not only regulatory, which have
been most decisive for the growth of the sector. The second part focuses
on the empirical evidence of the impact of ESG integration on the assess-
ment of financial performance and on the fundamental role of ESG
disclosure as a strategic management tool for a company.

Keywords Ethical investing · Sustainable investing · Socially

Responsible Investing (SRI) · ESG investing · ESG disclosure

A sustainable world needs sustainable finance. The general awareness of

the significant impact of finance in making the world more sustainable
can be summed up in this way: sustainability or sustainable development
refers to the concept of meeting present needs without compromising
the ability of future generations to meet their needs. It encompasses
social welfare, protection of the environment, efficient use of natural

© The Author(s), under exclusive license to Springer Nature 73

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3_6
74 E. BOLOGNESI

resources, and economic well-being. Thus, sustainable finance combines

sustainability needs with economic goals.
The European Commission defines sustainable finance as the process
of taking environmental, social, and governance (ESG) considerations
into account when making investment decisions in the financial sector,
leading to more long-term investments in sustainable economic activities
and projects. In the EU’s policy context, sustainable finance is under-
stood as finance to support economic growth while reducing pressures on
the environment and taking into account social and governance aspects.
Sustainable finance also encompasses transparency when it comes to risks
related to ESG factors that may have an impact on the financial system,
and the mitigation of such risks through the appropriate governance of
financial and corporate actors.
Before delving into the impact of this new investment approach on the
asset management industry, it is appropriate to provide some clarifications
on the terminology used over time. The term Sustainable Investing (SI)
has evolved during the last several decades. As a result, it is a field with
a substantial number of terms and acronyms, many of which are used
interchangeably or defined differently by various market participants.
Fulton et al. (2012) present a timeline of the evolution of sustain-
able investing that helps in better understanding this field. The starting
point, far into the past, is the birth of the concept of ethical invest-
ment which is an investment philosophy guided by moral values, ethical
codes, or religious beliefs. Investment decisions include non-economic
criteria which, in practice, are traditionally declined through negative (or
exclusionary) screening. From the 1960s to the mid-1990s, the focus
has shifted towards a broader concept of Socially Responsible Investing
(SRI) that represents an evolution of the ethical investment approach.
In its early stage, SRI was quite close to the ethical investing princi-
ples in that it allowed a level of trade-off between corporate social and
financial performance when making investment decisions, and predomi-
nantly used exclusionary screening. Moreover, SRI originally emerged as
a response to concerns over issues such as human rights, labour standards,
and environmental degradation. The goal was to create investment strate-
gies that align with investors’ values and avoid investments in companies
that engage in practices deemed harmful.
During the first half of the 2000s, SRI evolved into what is now known
as ESG investing , which takes a broader and more systematic approach
to integrating environmental, social, and governance considerations into
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 75

investment decision-making. Thus, ESG investing considers not only the

ethical implications of investments but also their potential impact on
financial performance. More in detail, Environmental issues concern any
aspect of a company’s activity that affects the environment in a positive
or negative manner. Examples include greenhouse gas emissions, renew-
able energy, energy efficiency, resource depletion, chemical pollution,
waste management, water management, impact on biodiversity, etc. Social
issues vary from community-related aspects, such as the improvement of
health and education, to workplace-related issues, including the adher-
ence to human rights, non-discrimination, and stakeholder engagement.
Examples include labour standards (along the supply chain, child labour,
forced labour), relations with local communities, talent management,
controversial business practices (weapons, conflict zones), health stan-
dards, freedom of association, etc. Governance issues concern the quality
of a company’s management, culture, risk profile, and other characteris-
tics. It includes the board accountability and their dedication towards,
and strategic management of, social and environmental performance.
Furthermore, it emphasises principles, such as transparent reporting and
the realisation of management tasks in a manner that is essentially free
of abuse and corruption. Examples include corporate governance issues
(executive remuneration, shareholder rights, board structure), bribery,
corruption, stakeholder dialogue, lobbying activities, etc.
Finally, the term Responsible Investing (RI) refers to the integration of
ESG considerations into investment management processes and owner-
ship practices in the belief that these factors can have an impact on
financial performance, in particular over the medium to long term.

Sustainable Investing
Origins and Evolution
To understand the philosophy behind sustainable finance, it is necessary
to retrace the main steps of its evolution. The first forms of SI date back to
the early 1900s in the United States. The 1920s were the years of prohibi-
tion and it also had an effect on the allocation of savings. It dates back to
1928 when we can identify the first fund linked not only to the logic
of profit maximisation. This was the Pioneer Fund, whose investment
strategy was based on the purchase of shares with high intrinsic value
and undervalued by the market and, at the same time, was concerned
76 E. BOLOGNESI

with avoiding investing in companies whose main business was linked

to alcohol and tobacco. Another important influence on investment
approaches was the period between the 1960s and 1970s characterised
by the rise of racial equality, women’s rights, consumer protection, and
anti-war movements. These movements led to the creation of the first
mutual funds whose policies were based on values related to faith, sensi-
tivity to civil rights, and concern for environmental dynamics. It should be
remembered that, at the end of the 1960s, the United States was engaged
in the Vietnam War, a sensitive issue for both citizens and investors.
Dissent to this war was on the rise across the country as the thought
that investors’ portfolios could profit from the war effort forced many
of them to revise their investment strategies. In 1971, the first SRI fund
was launched in the United States: the Pax World Fund. The aim of this
fund was to provide a way for investors to align their investments with
their values. Initially, the fund was focused on avoiding investments in
companies that were involved in the war in Vietnam. However, over time,
the fund’s focus expanded to include a broader range of environmental,
social, and governance (ESG) issues. In the 1990s, the fund began to
gain wider recognition as interest in socially responsible investing grew. It
also became one of the first mutual funds to sign on to the UN Principles
for Responsible Investment (PRI) in 2007. The launch of the Pax World
Fund and its success increased the momentum for this type of investment
and led to the general awakening of the environmental movement in the
country.
After the inception of the Pax World Fund, a series of environmental
and consumer protection measures were launched, among which we recall
the Clean Water Act of 1972 followed by the Endangered Species Act in
1973. Therefore, while the company was reacting to the war, to climate
change, to the trafficking of human beings, and a range of political
and cultural issues, even socially responsible investors followed suit by
directing their investments in support of these causes. It became clear
that the SRI movement, supported by investors and corporations, was
intent on remaining, as well as moving forward.
The evolution of the SRI movement also continued in the 1980s,
where in particular concerns for the environment and climate change
began to arise in the wake of the catastrophes of Bhopal, Chernobyl, and
Exxon Valdez. In 1984, the ‘US Sustainable Investment Forum’ (SIF)
was born, and today it is one of the major resources for SRI and impact
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 77

investing. The portfolio approach of the 1980s involved building a port-

folio that behaved like the traditional market by avoiding investments in
alcohol, tobacco, weapons, gambling, and environmental pollution. In
1984 another important socially responsible fund was born, namely the
Stewardship Friend.
The 90s were characterised by a strong development of SRIs: in 1992
the Cadbury report was in fact published, the importance of which was
that of having introduced the ‘comply or explain principle’, i.e., the prin-
ciple according to which companies are required to launch a self-discipline
code and must justify all the choices that deviate from these princi-
ples in the event that they decide not to respect it. In 1995, however,
the first report on sustainable finance was published, ‘Trend report on
SRI finance’, by the USSIF, and in 1999, the ‘Global Sullivan Princi-
ples’ were presented, a code of conduct concerning issues of respect for
human rights, a code for any type of company. The popularity of SRI
mutual funds continues to grow, combined with the need for a method-
ology able to measure and monitor the performance. Thus, in 1990 the
Domini Social Index (today named MSCI KLD 400 Social Index) was
launched, consisting of 400 companies listed in the United States that
met certain social and environmental standards. In fact, one of the main
taboos related to the issue of socially responsible investments, and which
in part still persists today, is that many investors feared that these would
present lower performances than traditional investments. Therefore, the
construction of this index has facilitated the comparison of the risk and
return profile of the portfolios built according to these principles with the
traditional ones.
In the early 2000s, SRI continued to gain more and more acclaim from
the public and investors, together with the introduction of important
initiatives and funds. In particular, we recognise three important ‘catalysts’
that drove the demand for analysis of ESG performance by investors. The
first concerns the heartfelt debate on the relationship between fiduciary
duty and sustainability issues; the second concerns climate change; the
third aims at supporting the argument that poor corporate governance is
bad for markets.
In 2006, the United Nations Principles for Responsible Investment
were launched with the aim of establishing guidelines for investors in
integrating ESG criteria into investment practices. Socially responsible
investors also seek to go beyond SRI by favouring investments that have
a positive impact. This approach was strengthened in 2015 by the United
78 E. BOLOGNESI

Nations Sustainable Development Goals. These goals, known as SDGs,

supported by all 193 member states of the United Nations, are an urgent
invitation to try to solve the challenges related to the development of the
most needy areas of the world as well as address and overcome issues such
as poverty, inequality, climate change, environmental degradation, peace,
and justice in the world.
It is in this period that the acronym ESG also begins to be used.
In fact, the birth of the ESG acronym is more recent than SRI, as
the first time it was adopted was in 2006, the year of publication of
the report ‘Who Cares Wins’. This report underlined the centrality of
the ESG theme as a driving factor for the generation of value in the
long term. At the same time, a group of United Nations Environ-
ment Programme Finance Initiative (UNEP FI) asset managers together
with Freshfields Bruckhaus Deringer, a leading international law firm,
published a ground-breaking report titled ‘A Legal Framework for the
Integration of Environmental, Social and Governance Issues into Insti-
tutional Investment’. Widely referred to as the ‘Freshfields Report’, the
landmark report argued that ‘integrating ESG considerations into an
investment analysis so as to more reliably predict financial performance
is clearly permissible and is arguably required in all jurisdictions’. We can
consider this report as one of the most effective documents for promoting
the integration of ESG issues in institutional investment.
Moreover, in 2006, the famous ‘Principles for Responsible Invest-
ments’ (PRI) has been launched, considered a fundamental step for the
integration of ESG factors in the investment selection process. In more
detail, the PRI is a global initiative that aims to promote the integration
of ESG factors into investment decision-making and ownership prac-
tices. The PRI is supported by a network of international signatories,
including institutional investors, asset managers, and service providers.
Since launching, these principles have evolved significantly as follows:
(i) Growth in signatories: The PRI has experienced significant growth
in signatories, with more than 4,000 signatories from over 60 coun-
tries representing over $100 trillion in assets under management, as of
2021. This growth has helped to increase the influence of the PRI and
promote the integration of ESG factors in investment decision-making.
(ii) Expansion of the principles: The PRI has expanded the original
six principles to include more detailed guidance on how to implement
responsible investment practices, as well as additional guidance for specific
asset classes and investment strategies. (iii) Increased focus on climate
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 79

change: The PRI has increased its focus on climate change, recognising
it as a systemic risk that poses significant challenges to the long-term
sustainability of the global economy. The PRI has developed specific tools
and initiatives to help investors address climate change, such as the PRI’s
Climate Action 100+ initiative and its Net Zero Asset Owner Alliance. (iv)
Emphasis on impact investing: The PRI has emphasised the importance
of impact investing, which seeks to generate positive social and envi-
ronmental outcomes alongside financial returns. The PRI has developed
guidance for investors on how to integrate impact investing into their
investment strategies. (v) Greater collaboration: The PRI has fostered
greater collaboration among investors, asset managers, companies, policy-
makers, and civil society organisations to promote responsible investment
practices and drive positive change in the global economy.
In the following years, many events took place which had a signif-
icant impact on the evolution of the sector, such as to place of ESG
investment at the centre of portfolio management. In 2015, the Paris
Agreement, based on the United Nations Framework Convention on
Climate Change, resulted in an explosive growth of public interest in
ESG with the respective further growth of social responsibility in the
asset management industry. This agreement was an important mile-
stone for companies and regulators united by clear and shared objectives.
The virtuous circle created by regulation and capital markets is remark-
able; significant pressure for regulatory development comes from capital
markets requiring more and higher quality information for valuation
purposes. EU policymakers are aware of the capital markets’ role in
mitigating sustainability risks and have taken an increasingly hard-line
approach to implementing relevant legislation. During the same year, the
UN adopted the seventeen Sustainable Development Goals (SDGs), which
provide a framework for sustainable development and cover issues such as
poverty, education, health, and climate change. Many investors now use
the SDGs as a guide for setting their ESG priorities and measuring the
impact of their investments.
In 2018, the European Commission published the EU Action Plan
on Sustainable Finance which is a comprehensive set of measures aimed
at mobilising capital towards sustainable investments and ensuring that
financial markets contribute to a more sustainable economy. The docu-
ment includes a range of policy initiatives and regulatory measures that
we can summarise as follows: (i) Taxonomy Regulation: This regulation
provides a classification system for sustainable economic activities and
80 E. BOLOGNESI

helps to define what can be considered a sustainable investment. It aims to

reduce the risk of ‘greenwashing’ and improve transparency in sustainable
finance. (ii) Disclosure Regulation: This regulation requires companies
and financial institutions to disclose ESG information in a standardised
and comparable way. It aims to improve the transparency of ESG risks and
opportunities and ensure that investors have access to reliable and relevant
ESG information. (iii) Low Carbon Benchmark Regulation: This regula-
tion requires investment managers to disclose how they integrate ESG
factors into their investment decisions and to use a low carbon bench-
mark when managing passive funds. (iv) Green Bond Standard: The EU
has developed a green bond standard that provides guidelines for issuers
of green bonds, ensuring that they meet certain criteria for environmental
sustainability.
Accordingly, in March 2021 the EU Sustainable Finance Disclosure
Regulation (SFDR) came into force requiring asset managers and other
financial firms to disclose how they integrate sustainability risks into their
investment decisions and to report on the ESG performance of their prod-
ucts. This regulation has had a significant impact on the ESG investing
landscape in Europe. Finally, we have witnessed a significant growth of
green bonds, used to finance environmentally friendly projects. According
to the Climate Bonds Initiative, the global green bond market reached
$305 billion in 2020, up from $271 billion in 2019.
All of these measures represent a landmark change in the industry that
stands to transform sustainable finance from an optional consideration to
a focal point of the European fund industry (PwC, 2020). The impact
of this epochal transformation on the asset management industry can be
seen both in the flows of investments in ESG products, which grew expo-
nentially, and in the number of funds (assets and ETFs) launched in the
recent few years, exceeding 3,000 units.

ESG Factors
As already mentioned, we are seeing an exponential growth in the use
of ESG principles in investment decisions. It is therefore appropriate to
delve into the meaning of the individual pillars that make up the ESG
approach. These three ESG pillars are, in turn, divided into several sub-
topics which constitute the entire architecture on the basis of which the
ESG scores and ratings are implemented. Figure 6.1 shows a graphical
synthesis of the topics covered by each pillar.
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 81

Fig. 6.1 ESG pillars and sub-topics (Source Author elaboration)

ENVIRONMENTAL—The E factor indicates how much an organisa-

tion considers the protection of natural resources. Thus, it is focused on
the environmental dimension and includes both short-term risks (i.e., the
increase in the price of energy goods or a particularly stringent taxonomy
towards the use of fossil fuels), and long-term risks (i.e., extreme climatic
events, such as prolonged periods of drought, or global warming).
Furthermore, in analysing environmental risk and environmental impact,
the company takes into account its entire supply chain.
Part E is divided into three subsets:

. Eco-efficiency: by eco-efficiency we mean that set of activities aimed

at minimising the use of resources for each unit produced: it can be
implemented, for example, through the use of recycled materials, the
reduction of waste, and energy efficiency.
. Environmental impact: this issue is the most relevant, as each
company, in order to be able to create stable profits in the long term,
82 E. BOLOGNESI

must be aware of the risks it runs at an environmental level and their

possible impact on the core business.
. Environmental management: this concerns the elaboration and
disclosure of the strategies adopted to manage the environmental
risks.

SOCIAL—The social pillar of ESG is wide ranging: it spans everything

from diversity and inclusion to human rights, health and safety, security,
ethics, and indigenous reconciliation. Pillar S includes all those aspects of
social development which include both relationships with primary stake-
holders and relationships with secondary stakeholders. We can identify the
following issues:

. Employment: the focus is on those practices that the company adopts

to ensure fair and dignified treatment of its employees. The main
items in the labour dimension are: adherence to labour laws, prepa-
ration of safety protocols, fair and non-discriminatory treatment and
wages, and fair trade with suppliers.
. Social development outside the company: this refers to all those
projects that aim to improve the social conditions of citizens, with
particular attention to developing countries. By way of example,
we can include all those campaigns that aim to combat the viola-
tion of human rights, wars, regimes, and in general all situations of
social unease. A particularly crucial aspect of this issue concerns the
possibility that the company, while participating in numerous social
development campaigns, stipulates supply contracts with companies
that operate without respecting the human rights of workers and
the environment. When this news becomes public knowledge, the
company could suffer a huge reputational damage, as the positive
activities it supports would qualify as greenwashing and the company
would face heavy criticism.

GOVERNANCE—The third dimension is certainly the most impactful at

the core business level, as the effects of mismanagement are tangible in
both the short and long term. A wide academic literature demonstrates
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 83

how an opaque policy at the level of governance has a great impact, espe-
cially during market drawdowns. In this context, the main indicators that
are taken into consideration are the following:

. Level of rights, activism, and involvement of shareholders and

stakeholders;
. Structure of the board of directors and its composition;
. Presence of adequate internal rules and regulations;
. Independence of the audit function, and transparency in the
decision-making process of strategic operations.

ESG Disclosure
A growing number of companies are embracing ESG principles and,
as a consequence, the tools available to investors and financial analysts
are increasingly sophisticated. While being ESG-compliant has become a
strategic asset, ESG disclosure is, to a greater extent, a requirement for
companies of all sizes. Thus, ESG disclosure has assumed an increasing
relevance in the broader Non-Financial Reporting (NFR) framework.
The growing attention on sustainability and the determination of homo-
geneous ESG criteria is pervasive and involves issuers, investors, and
regulators.
The companies’ current attitude towards the ESG disclosure is the
result of a voluntary strategic choice that is a response, on the one hand,
to the growing stakeholders’ request for transparency and, on the other,
to adapt to the development of the national and supranational NFR regu-
lation. Despite the growing attention to the improvement of disclosure,
the NFR regulatory process is far from being conclusive for two reasons:
(1) NFR regulation still differs substantially between geographical areas
and (2) it must address the trade-off between the stringency of ‘minimum
standards’ and the flexibility arising from ‘best practices’ (Jackson et al.,
2020).
From this perspective, Europe stands as a global leader in ESG thanks
to its strong regulatory and legislative structure. The European Union
Directive 2014/95 (NFRD) on non-financial and diversity information
represents an important regulatory move towards harmonising the NFR
practices of all European Member States and marks a shift in NFR
84 E. BOLOGNESI

from a voluntary exercise to one that is mandatory for the undertak-

ings concerned (Kinderman, 2020; La Torre et al., 2018). However,
the NFRD leaves a fair amount of flexibility in the implementation of
its provisions because it does not require the use of an NFR standard,
nor does it impose detailed disclosure requirements (such as lists of indi-
cators per sector). Accordingly, it gives companies significant flexibility
to disclose relevant information in the way they consider most useful.
As a result, companies may include a non-financial statement in their
management report or, under certain conditions, prepare a separate report
(European Parliamentary Research Service, 2021).
As already mentioned, the 2015 Paris Agreement has had a signif-
icant impact on ESG disclosure, particularly regarding climate-related
risks and opportunities. This agreement aims to limit global warming to
well below 2 degrees Celsius above pre-industrial levels and to pursue
efforts to limit the temperature increase to 1.5 degrees Celsius. As a
result, many investors have recognised the potential risks and oppor-
tunities associated with climate change and have started to incorporate
climate-related factors into their investment decision-making processes.
This has led to a growing demand for more consistent and comparable
ESG disclosure. In response to this demand, a number of frameworks
and initiatives have emerged that aim to improve ESG disclosure and
standardisation. One such initiative is the Task Force on Climate-related
Financial Disclosures (TCFD), which was established by the Finan-
cial Stability Board in 2015. The TCFD provides recommendations for
disclosing climate-related financial risks and opportunities in a consistent
and comparable manner, with the goal of improving the transparency and
comparability of climate-related information. The Paris Agreement has
also led to an increase in the number of companies that are disclosing
their climate-related risks and opportunities. In 2015, the number of
companies that reported their climate-related information through the
CDP (formerly known as the Carbon Disclosure Project) was around
4,000. By 2020, this number had increased to over 9,600, representing a
significant increase in ESG disclosure related to climate-related risks and
opportunities.

The Impact of the ESG Integration on Financial Performance

A broad body of research focuses on the impact of ESG integration on
a firm’s financial performance, following different perspectives, measures,
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 85

and methodologies. Research on this theme attempts to establish how

social norms, markets, and institutions work individually or together in
a complex process so that responsible firm behaviour converges with
profitable firm behaviour (Kölbel et al., 2017).
Older academic literature, based on the agency cost theory, argues
that the costs incurred by Corporate Social Responsibility (CSR) actions
are additional costs and, therefore, have a negative impact on the firm’s
performance. In particular, Friedman (1970) stated that the only social
responsibility of business is to make profits. On the one hand, if managers
use corporate resources for socially responsible activities, they do so
as agents fulfilling their own self-interest rather than making decisions
for the benefit of shareholders. On the other hand, stakeholder theory
postulates that CSR activities will result in financial gain (Jones, 1995).
Later, Freeman (1984), introducing stakeholder theory of organisational
management and business ethics, argues that a firm should create value
for all stakeholders, not just shareholders, addressing morals and values
in managing an organisation. In this view, CSR activities can alleviate
conflicts of interest between companies and stakeholders and ultimately
increase financial performance and corporate value (Bartlett & Preston,
2000; Cochran et al., 1985).
More recent studies demonstrate a significant value creation of ESG
integration and its disclosure under multiple profiles, including: repu-
tation improvement (Khojastehpour & Johns, 2014; Unerman, 2008);
organisational attractiveness (Albinger & Freeman, 2000; Jamali et al.,
2015); lower capital constraints and lower cost of capital (Cheng et al.,
2014; El Ghoul et al., 2011; Francis et al., 2005); and creation of
insurance-like protection (Godfrey et al., 2009).
From an accounting perspective, a vast amount of literature demon-
strates that ESG activities and disclosure have a positive impact on a firm’s
financial performance. Dhaliwal et al. (2011) and El Ghoul et al. (2011)
show that companies that initiate CSR reporting or firms with higher CSR
scores enjoy a reduction in the cost of equity capital. Plumlee et al. (2015)
confirm the positive relation between voluntary environmental disclosure
quality and firm value in terms of expected future cash flow and cost
of equity capital. Cheng et al. (2014) investigate whether CSR strategies
affect the firm’s ability to access finance in capital markets, confirming that
higher levels of transparency reduce informational asymmetries between
the firm and investors, thus mitigating perceived risk. Kim et al. (2012)
argue that firms that exhibit CSR also behave in a responsible manner
86 E. BOLOGNESI

to constrain earnings management, thereby delivering more transparent

and reliable financial information to investors. Focusing on the UK stock
market, Li et al. (2018) find a positive association between ESG disclosure
level and firm value (Tobin’s Q), suggesting that improved transparency,
accountability, and enhanced stakeholder trust play a role in boosting firm
value. Still based on Tobin’s Q as a proxy of firm value, Fatemi et al.
(2018) demonstrate that ESG strength increases the firm value and that
ESG disclosure has a negative effect, motivated by the investor’s view
of such disclosure as ‘greenwashing’. Drempetic et al. (2019) stress the
importance of ESG reporting on the ESG score. They argue that the ESG
score is distorted in favour of larger companies, because ESG scores are
dependent on resources for providing ESG data and data availability of
the ESG score. Wong and Zhang (2022) examine the effects of adverse
media coverage of ESG issues on firm-level stock performance showing
that investors perceive the corporate reputation as an intangible asset to
be preserved. Recently, scholars have been investigating the effects of
ESG policies on financial markets without reaching a conclusive point,
as the literature presents conflicting results (Khan, 2022). Moreover, as
reported by Huang et al. (2022), several studies state that higher ESG
performances are associated with lower risks with particular reference to
systematic risk (Albuquerque et al., 2019), credit risk (Mendiratta et al.,
2021), crash risk (Feng et al., 2022), downside risk (Hoepner et al.,
2021), and idiosyncratic risk (He et al., 2022).
Moving to the financial markets perspective on the ESG disclosure,
Dhaliwal et al. (2011) highlight that voluntary CSR disclosure is asso-
ciated with increased analyst coverage, improved forecast accuracy, and
reduction in forecast dispersion among firms with relatively superior CSR
performance. Chung and Jo (1996) demonstrated a positive relation-
ship between analyst coverage and corporate social performance. Wang
et al. (2022) show that the quality of information disclosure improves the
quality of information production by financial analysts.
Focusing on the impact of ESG disclosure on the analyst evaluations,
Ioannou and Serafeim (2015) explore the relationship between CSR
ratings and the sell-side analysts’ assessment of US firms’ future finan-
cial performance over a 15-year period. They find empirical evidence
of a gradual shift from an initial unfavourable evaluation of firms with
high CSR scores (motivated by the detriment of corporate profitability,
i.e., agency cost) to a more optimistic evaluation (motivated by the
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 87

increasing belief that CSR does not penalise a firm’s financial perfor-
mance and even may generate value in the long run). Luo et al. (2015)
argue that analyst recommendations mediate the relationship between
CSR and future stock returns. They argue that, given the growing
relevance of social investing and fund managers’ quest for ‘investment
with a conscience’, more frequently firm corporate social performance
is addressed as an intangible and promising asset by analysts. Bolognesi
and Burchi (2023) focus on the impact of ESG disclosure scores on sell-
side analysts’ target prices. Focusing on the largest 3,000 US-listed firms
between 2012 and 2020, they argue that the ESG disclosure is a value
driver for sell-side analysts. ESG factors affect a community’s long-term
sustainability and serve to guide the broader financial markets, increas-
ingly oriented towards sustainable investing. Specifically, they find that:
(1) analysts recognise a premium for firms more engaged in ESG trans-
parency (2) before the Paris Agreement this premium was mainly driven
by Governance disclosure; (3) after this event this premium has also been
driven by Environmental disclosure. Thus, their findings demonstrate that
ESG disclosure is a strategic tool for firms to create value.

The Impact of Regulation on ESG Disclosure

In Europe, ESG disclosure has been constantly growing and, since the
early 2000s, has been the subject of study by both European policy-
makers and national governments. The push towards the transition from
voluntary towards mandatory disclosure has been gradual, with many
steps being taken to draw up guidelines that could be implemented by
companies belonging to different sectors.
To summarise the main steps taken in Europe in terms of NFR, we
recall the European Union Directive 2014/95 on non-financial and diver-
sity information (referred to as the ’Non-Financial Reporting Directive’).
This Directive requires companies from 2018 onwards to include non-
financial statements in their annual reports or in a separate filing. This
includes information on environmental protection, social responsibility
and treatment of employees, respect for human rights, anti-corruption
and bribery, and diversity on company boards. It applies to public-
interest companies with more than 500 employers, which constitutes
approximately 6,000 companies and groups.
In June 2017, the European Commission (EC) provided Guidelines on
NFR to help companies disclose relevant non-financial information in a
88 E. BOLOGNESI

more consistent and comparable manner. In June 2019, the EC published

additional guidelines on reporting climate-related information which inte-
grate recommendations by the Task Force on Climate-related Financial
Disclosures. Moreover, in December 2019, the EC published the commu-
nication The European Green Deal (European Commission, 2019). This
document reformulated the European commitment to tackle climate and
environmental problems on a new basis, aiming at achieving the targets
of the Energy and Climate Strategy, already established at the legislative
level in the Clean Energy Package.
The European Green Deal presents a roadmap for making the EU’s
economy sustainable and aims to boost the efficient use of resources by
moving to a clean, circular economy, towards averting climate change,
biodiversity loss, and pollution. The European Green Deal covers all
sectors of the economy, notably transportation, energy, agriculture,
building construction, and infrastructure industries such as steel, cement,
ICT, textiles, and chemicals. Furthermore, in 2020, the EU published
the Taxonomy Regulation (EU 2020/852) which is a classification system
that provides companies, investors, and policymakers with appropriate
definitions for which economic activities can be considered environ-
mentally sustainable. In this way, it should create security for investors,
protect private investors from greenwashing, help companies to become
more climate-friendly, mitigate market fragmentation, and help shift
investments where they are most needed.
In the United States, the approach to ESG disclosure discipline has
alternatively followed a market-based approach often referencing disclo-
sure frameworks established by non-governmental entities to establish
similar frameworks. Therefore, in the United States, sustainable investing
and disclosure has been guided by voluntary, private-sector-led processes,
protocols, and guidelines. More specifically, there are no mandatory ESG
disclosures at the federal level. The Securities and Exchange Commission
(SEC) requires all public companies to disclose information regarding
human capital resources and measures or objectives if it is material to
the understanding of the business. For example, in 2010, the SEC issued
guidance regarding how the US securities laws and regulations may
require disclosures of climate-related information, depending on a compa-
ny’s circumstances. However, there is general agreement that the level
of information that US companies are compelled to disclose under the
existing regulatory framework is significantly lower than in a number of
other developed markets (EY, 2021).
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 89

To compare the dynamic of the ESG disclosure of European and US

firms, we analyse the scores of the components of two broad equity
market indices. We have focused on the Bloomberg Europe Large,
Mid, & Small Cap Index because it covers approximately 99% of the
investable European markets, including 1,910 firms. For the United
States, we have selected the Russell 3000 Index because it covers about
98% of the investable US equity market and constitutes 3,020 firms.
The observation period is 2012–2020. For ESG disclosure we have used
scores provided by Bloomberg. Composite ESG scores range from 0.1 for
companies that disclose a minimum amount of ESG data to 100 for those
that disclose every data point collected by Bloomberg. Each data point is
weighted in terms of importance. The overall score is also tailored to
different industry sectors. The score measures the amount of ESG data a
firm publicly reports. We also use the same approach for testing separate
E, S, and G scores.
Figure 6.2 shows the dynamics of both the overall ESG score and the
three pillars. We can at first notice an overall increase in the median values
of the scores and a reduction in their interquartile distance. Moreover,
the comparison between the two samples shows significantly different
dynamics. In fact, in Europe, average disclosure scores are higher than in
the United States. Furthermore, the growing trend in Europe is constant
and noticeable. Looking in more detail at the data on US disclosure,
a greater lack of homogeneity with respect to the European ones is
evident. In particular, the significant number of outliers for each pillar
is surprising at first. Furthermore, the difference between disclosure in
governance compared to the other pillars is evident; in this case the values
are significantly higher, indicating a greater culture towards this issue than
environmental and social concerns.
This evidence demonstrates that Europe and the United States have
taken different paths towards sustainability reporting. This is largely the
result of differences in governance, regulatory culture, and the balancing
of domestic interests: European companies showing significant qualitative
and quantitative improvement in their ESG disclosures compared to US
companies. This difference is likely attributable to the regulatory context
that progressively has become increasingly structured and stringent for
European companies.
90 E. BOLOGNESI

European Stocks (Bloomberg Europe Large, Mid, & Small Cap Index)
ESG score E - score
80

80
60

60
40
_

40
20

20
0

0
E
S - score G - score
S G
100

100
80

80
60

60
40

40
20

20
0

US Stocks (Russell 3000 Index)

ESG score E - score
80

80
60

60
40

_
40
_
20

20
0

S - score G - score
80

80
60

60
_
40

40
20

20
0
0

2011 2012
2013 2014
2015 2016
2017 2018
2019 2020

Fig. 6.2 Boxplot visualisation of ESG disclosure scores by year (Source Author’s
computation on Bloomberg data)
 6 THE NEED FOR A CHANGE: SUSTAINABLE FINANCE 91

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 CHAPTER 7

The Next Challenge: ESG

and CLIMATE Investing

Abstract This chapter focuses on the most recent investment approaches

dictated by investors’ growing awareness of the positive impact that
finance can have on sustainability and climate change mitigation. We
will first focus on ESG investing and on the main tool available to the
manager for defining the portfolio, i.e., the ESG ratings. A description
of the main rating providers will be provided, emphasising the problem
of divergence in ratings as well as the size effect. The main sustainable
investment strategies will then be listed. We will therefore focus on climate
investing, briefly listing the European regulatory process that led to the
sudden development of this investment philosophy. Finally, we will focus
on the ESG and climate indices and on the risk and return profiles of a
sample of these indices.

Keywords ESG ratings · ESG Investing · ESG Indexing · Climate

Investing · Climate Indexing

Structural and systematic shifts, such as climate change, resource scarcity,

regulatory pressures, and the importance of human capital and diver-
sity, increasingly pose material business risks and, simultaneously, present
opportunities to issuers and investors globally. Consequently, numerous
investors use ESG information because of client demand or as part of their

© The Author(s), under exclusive license to Springer Nature 95

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3_7
96 E. BOLOGNESI

product development process. As the investor community continues to

signal more interest in sustainability and ESG data, the value of external,
third-party ratings has increased. These ratings, prepared for individual
companies, are intended to be used by investors to evaluate their port-
folios, by sustainability professionals for benchmarking against peers, and
by sell-side financial analysts for their companies’ forecasts.
ESG investing is gaining traction as investors increasingly seek long-
term value and alignment with sustainability and climate-related objec-
tives. Asset managers globally are expected to increase their ESG-
related assets under management (AuM) to US$33.9tn by 2026, from
US$18.4tn in 2021 (PwC, 2020). With a projected compound annual
growth rate of 12.9%, ESG assets are on track to constitute 21.5% of total
global AuM in less than five years. It represents a dramatic and contin-
uing shift in the asset and wealth management industry. The report also
captures the views of 250 institutional investors and asset managers world-
wide, representing nearly half of global AuM. Consistently, investors’
preferences for an ESG strategy continued to drive inflows in actively
managed ESG funds, while their non-ESG actively managed counterparts
continued to experience outflows (Deloitte, 2022).

ESG Investing
ESG Ratings: Main Actors and Methodologies
ESG ratings are based on a materiality framework that measures a compa-
ny’s exposure to industry-specific material ESG and how well a company
is managing those ESG risks. In other words, ESG ratings provide a
score on ESG sustainability, and therefore they are not linked to a purely
financial measurement. ESG ratings first emerged in the 1980s as a way
for investors to screen companies on ESG performance. EIRIS (Ethical
Investment Research Services) is one of the earliest ESG rating agencies,
having been founded in 1983. EIRIS was initially focused on providing
research and analysis to socially responsible investors, and later expanded
its services to include ESG ratings of companies. Since then, the market
for ESG ratings has grown exponentially, especially in the past decade.
Because ESG ratings are an essential basis for most kinds of sustain-
able investing, the market for ESG ratings grew in parallel to sustainable
investing.
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 97

The number of ESG standards and frameworks, data providers, ratings,

and rankings has expanded over time, with more than 600 ESG ratings
and rankings existing globally as of 2018 and continuing to grow since
then (SustainAbility, 2020). In 2023, Bloomberg estimates 1,100 ESG
data providers worldwide. In recent years, major rating agencies have
purchased large stakes in ESG rating agencies, understanding the strong
synergies arising from the integration of the two activities and the strong
growth potential of the sector. As an example, in 2019 Moody’s has
acquired the majority of Vigeo EIRIS while S&P has acquired Robe-
coSAM, two leading companies in the ESG rating framework. It’s worth
noting that RobecoSAM includes the Corporate Sustainability Assessment
(CSA) division, whose algorithms form the basis of the popular Dow
Jones Sustainability Index.
Here we focus on the main raters in this sector which are also used
for the construction of sustainable and ESG indexes. It is appropriate to
briefly dwell on the general evaluation criteria and methodologies that
they adopt, without any claim to completeness:

– Sustainalytics;
– MSCI ESG Research;
– Bloomberg ESG Scores;
– FTSE Russell’s ESG Ratings;
– ISS ESG.
– Refinitiv ESG Scores

SUSTAINALYTICS is controlled by Morningstar group which uses the

data produced by its agency for the construction of the Morningstar
Sustainability Rating. The Sustainalytics approach is built with the aim
of highlighting the most relevant ESG risks for a company. Sustainalyt-
ics’ ESG Risk Ratings measure a company’s exposure to industry-specific
material ESG risks and how well a company is managing those risks. This
multi-dimensional way of measuring ESG risk combines the concepts of
management and exposure to arrive at an absolute assessment of ESG
risk. Sustainalytics identifies five categories of ESG risk severity that could
impact a company’s enterprise value: negligible, low, medium, high, and
severe and represented by the popular ESG Globes icon. These scores
are then used by Morningstar for the formation of its ratings, which
are constructed through a normalisation at sector level, which aims to
98 E. BOLOGNESI

avoid distortions that would prevent the investor from understanding how
much more or less ESG a company was compared to peers.
The MSCI ESG Research Division has been established in 2013 and
is responsible for providing reports and tools for analysing ESG factors.
In its rating methodology, MSCI follows a value-based approach, that
evolved, over time, thanks to the influence of the many companies that
have been acquired, from an initially strongly quantitative approach.
Specifically, the MSCI ESG rating is an average of the scores obtained
in the three different areas, which are an expression of the evaluation of
thirty-five different key factors. These scores are then calculated, taking
into account the sector, the time horizon in which the risk could mate-
rialise the possible economic impact, and are subsequently aggregated by
reference area. The overall ESG score will therefore be an arithmetic mean
of the scores for E, S, and G pillars. The MSCI ESG rating is similar to
the main non-ESG rating agencies, ranging from AAA to CCC. Thus, we
can identify the leaders as (AAA and AA), the average (A, BBB, BB), and
the laggard (B, CCC).
BLOOMBERG ESG SCORES. In 2020, Bloomberg has launched its
proprietary ESG scores, calculated using a methodology that incorporates
company-reported data, as well as third-party data sources. The rating
of each pillar is an expression of the grouping of different topics, which
in turn are divided into fields. Depending on the industry, Bloomberg
includes or excludes different fields, to improve comparability. The various
fields are given a score ranging from 1 to 10 (where 10 is the best score).
For the weighting of these factors in a theme, a calculation is made that
considers three different variables, which are: (1) Probability: a probability
of completion has been assigned to each field which can be low, medium,
or high; (2) Severity: each field is assigned a high, medium, or low severity
depending on the potential loss should that risk materialise; (3) Time
horizon: each field is assigned a score according to the time horizon of
the risk: low risk (5–10 years), medium risk (2–5 years), and high risk
(2 years). As reported by Bloomberg, the long-term time horizon usually
concerns physical risks, the medium-term one usually concerns regulatory
risks. Once the score of the various topics has been calculated, they are
corrected for the disclosure, which adds a point if adequately present.
Once the various topics have been calculated, they are grouped into the
different areas, and are weighted differently for each sector. Once these
scores have been calculated, their arithmetic mean leads to the formation
of the ESG score.
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 99

FTSE RUSSELL ESG RATINGS aims to synthesise ESG informa-

tion (both qualitative and quantitative) objectively into a single score;
it combines an issuer’s total ESG exposure and performance in multiple
dimensions. The final score attributed to any organisation rests on assess-
ments conducted for the three E, S, and G pillars, covering fourteen
themes, themselves spread over 300 indicators. Once the two scores have
been calculated for each indicator that is part of a relevant topic (those
with negligible exposure are excluded), a matrix is created which has the
task of providing the aggregate score of the topic. The issues are then
grouped by the area to which they belong and the ESG score will also
be an arithmetic mean of the value of these three pillars. The ESG score
provided by FTSE Russell ranges from 1 to 5.
REFINITIV ESG Scores are designed to measure a company’s relative
ESG performance, commitment, and effectiveness based on company-
reported data. This rating covers ten main themes including emissions,
environmental product innovation, human rights, shareholders, and so
on. It also provides an overall ESG combined (ESGC) score, which is
discounted for significant ESG controversies impacting the corporations
we cover. The percentile rank scores are available in both percentages
and letter grades from D- to A + . They are benchmarked against The
Refinitiv Business Classifications (TRBC—Industry Group) for all envi-
ronmental and social categories, as well as the controversies score. They
are also measured against the country of incorporation for all governance
categories. The ESG scores are data-driven, accounting for the most
material industry metrics, with minimal company size and transparency
biases. The scores are based on the relative performance of ESG factors
with the company’s sector (for environmental and social) and country of
incorporation (for governance). Refinitiv’s ESG scoring methodology has
the following key calculation principles: (1) ESG magnitude (materiality)
weightings; (2) Company disclosure; (3) ESG controversies overlay; (4)
Industry and country benchmarks at the data point scoring level, to facil-
itate comparable analysis within peer groups; (5) Percentile rank scoring
methodology, to eliminate hidden layers of calculations. This method-
ology produces a score between 0 and 100, as well as easy-to-understand
letter grades.
100 E. BOLOGNESI

ESG Ratings: Diverging Evaluations and Size Effect

As already mentioned, in 2023 we can count over 1,100 ESG data
providers worldwide. As a consequence, ESG ratings are not standard-
ised and different providers may have different rating systems, which can
lead to significant variations in the assessments of the same company.
Berg et al. (2022) argue that ESG rating agencies allow investors to
screen companies for ESG performance, like credit ratings allow investors
to screen companies for creditworthiness. However, they recognise at
least three important differences between ESG ratings and credit ratings.
First, while creditworthiness is relatively clearly defined as the proba-
bility of default, the definition of ESG performance is less evident. It is
a concept based on values that are diverse and evolving. Thus, an impor-
tant part of the service that ESG rating agencies offer is an interpretation
of what ESG performance means. Second, while financial reporting stan-
dards have matured and converged over the past century, ESG reporting
is in its infancy. There are competing reporting standards for ESG disclo-
sure, many of which are voluntary or limited to single jurisdictions, giving
corporations broad discretion regarding whether and what to report.
Thus, ESG ratings provide a service to investors by collecting and aggre-
gating information from across a spectrum of sources and reporting
standards. These two differences explain why the divergence between
ESG ratings is so much more pronounced than the divergence between
credit ratings, the latter being correlated at 99%. Third, ESG raters are
paid by investors who use the ratings, not by the companies that are rated,
as is the case with credit raters. As a result, the problem of rating shop-
ping, which has been discussed as a potential reason for credit ratings
diverging, does not apply to ESG rating providers. In their analysis, the
authors focus on six different raters (KLD, Sustainalytics, Moody’s ESG,
S&P Global, Refinitiv, and MSCI) and demonstrate that ESG ratings from
different providers disagree substantially, where the correlations range
between from 0.38 to 0.71.
Therefore, ESG raters, by not analysing purely quantitative aspects,
have the possibility of giving a subjective weight to the various factors
analysed, over or underweighting the importance of the variables consid-
ered and including or excluding certain aspects, which they could deem
not worthy of consideration or misleading. This disagreement has impor-
tant consequences. First, it makes it difficult to evaluate the ESG perfor-
mance of companies, funds, and portfolios, which is the primary purpose
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 101

of ESG ratings. Second, ESG rating divergence could discourage firms

from improving their ESG performance.
The lack of homogeneity in the ESG ratings must be added the
problem deriving from the empirical evidence of the positive correla-
tion between ESG ratings and company size. Academic literature has
widely highlighted this side effect. Drempetic et al. (2019) support this
correlation with the evidence that larger companies usually show greater
disclosure and can produce the data required by the rating agencies with
lower costs. This effort leads to higher ratings than those of smaller
competitors. In fact, whenever data are not available, rating agencies
assume the worst-case scenario instead of an average scenario, a choice
defined as a ‘non-trust system’. In support of this thesis, there is also the
tendency for public institutions to carry out studies that significantly over-
weight the impacts of large companies as the data are more easily available
and reliable. For this reason, especially when the agencies use only public
data, the effect of a greater number of data for large companies would be
even more significant.
Still focusing on the positive correlation between size and ESG scores,
on a theoretical level, we can provide explanations: in the first place, as
mentioned above, larger companies can be better organised to obtain
more data, which makes them ‘more ESG’ than the smaller, on average.
Secondly, it is easy to understand how, the larger a company is, the more
it is subject to external pressures: both local and national politics often
turn to businesses to adopt policies aimed at the social and environmental
improvement of the particular territory in which they are located.

Responsible Investment Strategies

Sustainable and responsible investments can be declined according to
alternative strategies, each of which is characterised by specific objectives
and methodologies. According to Eurosif, we can describe these strategies
as follows:
Best-in-class: An approach where leading or best-performing invest-
ments within a universe, category, or class are selected or weighted based
on ESG criteria. This approach involves the selection or weighting of
the best-performing or most improved companies or assets as identified
by ESG analysis, within a defined investment universe. This approach
includes ‘Best-in-class’, ‘Best-in-universe’, and ‘Best-effort’.
102 E. BOLOGNESI

Engagement & voting: Engagement activities and active ownership

through voting of shares and engagement with companies on ESG
matters. This is a long-term process, seeking to influence behaviour or
increase disclosure. Engagement and voting on corporate governance
only is necessary, but not sufficient to be counted in this strategy.
ESG integration: The explicit inclusion by asset managers of ESG risks
and opportunities into traditional financial analysis and investment deci-
sions based on a systematic process and appropriate research sources. This
type covers explicit consideration of ESG factors alongside financial factors
in the mainstream analysis of investments. The integration process focuses
on the potential impact of ESG issues on company financials (positive and
negative), which in turn may affect the investment decision.
Exclusions: An approach that excludes specific investments or classes
of investment from the investible universe such as companies, sectors, or
countries. This approach systematically excludes companies, sectors, or
countries from the permissible investment universe if involved in certain
activities based on specific criteria. Common criteria include weapons,
pornography, tobacco, and animal testing. Exclusions can be applied at
individual fund or mandate level, but increasingly also at asset manager or
asset owner level, across the entire product range of assets. This approach
is also referred to as ethical- or values-based exclusions, as exclusion
criteria are typically based on the choices made by asset managers or asset
owners.
Impact investing: Impact investments are investments made into
companies, organisations, and funds with the intention to generate social
and environmental impact alongside a financial return. Impact invest-
ments can be made in both emerging and developed markets, and target a
range of returns from below market-to-market rate, depending upon the
circumstances. Investments are often project-specific, and distinct from
philanthropy, as the investor retains ownership of the asset and expects
a positive financial return. Impact investment includes microfinance,
community investing, and social business/entrepreneurship funds.
Norms-based screening: Screening of investments according to their
compliance with international standards and norms. This approach
involves the screening of investments based on international norms or
combinations of norms covering ESG factors. International norms on
ESG are those defined by international bodies such as the United Nations
(UN).
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 103

Sustainability themed. Investment in themes or assets linked to the

development of sustainability. Thematic funds focus on specific or
multiple issues related to ESG. Sustainability-themed investments inher-
ently contribute to addressing social and/or environmental challenges
such as climate change, eco-efficiency, and health. Funds are required to
have an ESG analysis or screen of investments in order to be counted in
this approach.

ESG Investing and Regulation

As already mentioned, in Europe, ESG investing has been supported
by an intense regulatory process. In Fig. 7.1 we summarise the main
step of the European framework on sustainable finance with a particular
emphasis on those more impactful from the asset management industry.
We firstly recall, from Chapter 6, the 2014 Non-Financial Reporting
Directive (NFRD) as an important regulatory move towards harmonising
the disclosure practices of all European Member States. On December
2015, the Paris Agreement set out a global framework to avoid dangerous
climate change by limiting global warming to well below 2 °C and
pursuing efforts to limit it to 1.5 °C. In March 2018, the European
Commission published an ‘Action Plan for sustainable finance’, defining
the strategy for the creation of a financial system for the promotion of
sustainable development from an economic, social, and environmental
point of view, which may help the implementation of the Paris Agreement
on Climate Change and the United Nations 2030 Agenda for Sustainable
Development.
On 11 December 2019, the European Commission announced the
European Green Deal to transform the European Union into a modern,
resource-efficient, and competitive economy. The European Green Deal
provides a roadmap with actions to boost the efficient use of resources
by moving to a clean, circular economy and stop climate change, reverse
biodiversity loss, and cut pollution. It outlines investments needed and
financing tools available and explains how to ensure a just and inclusive
transition. The European Green Deal covers all sectors of the economy,
notably transport, energy, agriculture, buildings, and industries such as
steel, cement, ICT, textiles, and chemicals. The goal is to reach a climate-
neutral economy in the EU by 2050, with a reduction of 55% already
implemented in 2030. To achieve these climate goals, the Green Deal
includes an investment plan of 1 trillion euros over the next 10 years.
104 E. BOLOGNESI

2015 Paris Agreement on Climate Change Sets out a global framework to avoid dangerous climate
change. Encourage countries to take ambitious climate
actions that keep warming below 1.5°.

2018 Action Plan on Financing Sustainable Define the strategy for the creation of a financial system for
Growth the promotion of sustainable development from an economic,
social and environmental point of view. Reorient capital
flows towards sustainable investment, in order to achieve
sustainable and inclusive growth.

2019 European Green Deal Aim to transform the Union into a modern, resource-efficient
and competitive economy with no net emissions of
greenhouse gases (GHG) by 2050.

2020 EU Taxonomy Regulation Classification system that provides appropiate definitions for
which economic activities can be considered environmentally
sustainable.

2021 EU Sustainable Finance Disclosure Asset managers must disclose detailed information about the
Regulation (SFDR) sustainability characteristics of investment products.

2023 Corporate Sustainability Reporting Ensure that investors and other stakeholders have access to
Directive (CSRD) the information they need to assess investment risks arising
from climate change and other sustainability issues.

Fig. 7.1 EU regulatory framework on sustainable finance: A timeline (Source

Author’s elaboration)

Despite this huge investment, the EU depends also on the support of

the private sector to achieve the Paris climate agreement. To reach these
targets, further regulations have followed which have had an impact on
the asset management industry. First, one of the cornerstones of the
Green Deal is to bring clarity to the market regarding which economic
activities can be considered sustainable with the aim of encouraging
sustainable investing and preventing greenwashing. The EU Taxonomy
is an ambitious attempt to define these activities and the related technical
standards for six environmental objectives (see the following section on
Climate Investing). The Taxonomy Regulation was published in the Offi-
cial Journal of the European Union on 22 June 2020 and entered into
force on 12 July 2020.
Moreover, the EU Sustainable Finance Disclosure Regulation (SFDR)
came into effect in March 2021. This regulation requires asset managers
to disclose detailed information about the sustainability characteristics of
their investment products, including how ESG factors are integrated into
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 105

investment decision-making processes, and how the products align with

specific sustainability objectives. The SFDR applies to all financial market
participants that offer financial products within the European Union,
regardless of whether they are based in the EU or not. Thus, the SFDR
aims to increase transparency and improve the comparability of ESG-
related information provided by financial market participants, including
asset managers, investment funds, and investment advisors.
To briefly sum up the key impacts of SFDR on asset management, we
mention:

– Increased transparency: SFDR requires asset managers to provide

greater transparency on the sustainability characteristics of their
investment products. This includes disclosing the degree to which
ESG factors are considered in the investment process and the impact
of investment decisions on sustainability factors.
– Improved comparability: SFDR requires standardised disclosure of
sustainability information, which should make it easier for investors
to compare investment products based on ESG criteria.
– Enhanced due diligence: Asset managers are required to carry out
due diligence on the sustainability risks and impacts of their invest-
ments and disclose how they manage these risks. This could result in
more robust ESG policies and procedures.
– A shift towards sustainable investments: As investors increasingly
demand sustainable investment products, asset managers may need
to develop new products or adapt existing ones to meet this demand.
– Potential impact on performance: The SFDR may also have
an impact on the performance of investment products, as asset
managers may need to consider ESG factors when making invest-
ment decisions, which could affect portfolio composition and
returns.

Furthermore, on 5 January 2023, the Corporate Sustainability Reporting

Directive (CSRD) entered into force. This new directive modernises and
strengthens the rules concerning the social and environmental informa-
tion that companies have to report. A broader set of large companies, as
well as listed SMEs, will now be required to report on sustainability—
approximately 50,000 companies in total. The aim of these new rules is
106 E. BOLOGNESI

to ensure that investors and other stakeholders have access to the infor-
mation they need to assess investment risks arising from climate change
and other sustainability issues. Finally, reporting costs will be reduced for
companies over the medium to long term by harmonising the information
that is to be provided. The first companies will have to apply the new rules
for the first time in the 2024 financial year, for reports published in 2025.

Climate Investing
Climate investing refers to the investment in companies, projects, and
technologies that are focused on reducing the negative impact of climate
change. This includes investments in renewable energy, energy efficiency,
clean technology, sustainable transportation, and other initiatives that
contribute to the reduction of greenhouse gas emissions and the transition
to a low-carbon economy. Climate investing is driven by the recogni-
tion that climate change poses significant risks to the global economy and
society, and that urgent action is required to mitigate these risks. The
investment community is increasingly focused on climate investing as a
way to align financial returns with environmental and social goals.
As already mentioned, European regulation has exerted pressure to
develop this new investment approach and, as a consequence, has led
to increasing attention given to environmental objectives in invest-
ment choices and processes. In particular, the EU Taxonomy regulation
describes a framework to classify ‘green’ or ‘sustainable’ economic activi-
ties executed in the EU. Previously, there was no clear definition of green,
sustainable, or environmentally friendly economic activity. Compared to
their competitors, sustainable companies stand out positively and thus
should benefit from higher investments. More in detail, the focus of the
taxonomy lies in the six environmental objectives (see Fig. 7.2).
To be classified as a sustainable economic activity according to the
EU Taxonomy, a company must not only contribute to at least one
environmental objective but also must not violate the remaining ones.
An activity aiming to mitigate the climate but, at the same time, also
negatively affecting biodiversity cannot be classified as sustainable. The
classification of an economic activity in terms of sustainability is based
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 107

Fig. 7.2 EU Taxonomy: Environmental objectives (Source Author’s elabora-

tion)

on the following four criteria, which refer to the previously mentioned

environmental objectives:

. The economic activity contributes to one of the six environmental

objectives.
. The economic activity does ‘no significant harm’ to any of the six
environmental objectives.
. The economic activity meets ‘minimum safeguards’ such as the
UN Guiding Principles on Business and Human Rights to avoid a
negative social impact.
. The economic activity complies with the technical screening criteria
developed by the EU Technical Expert Group.

It is clear that the EU Taxonomy is closely related to climate finance, as

the former is designed to provide a framework for identifying sustainable
economic activities, including those related to climate change mitigation
and adaptation, and the latter is designed to provide financial resources
for such activities. In other words, the EU Taxonomy can help investors
and asset managers to identify sustainable investment opportunities, and
108 E. BOLOGNESI

climate finance can provide the necessary resources to fund those oppor-
tunities. In addition, the EU Taxonomy can help policymakers to design
effective policies and regulations that encourage investment in sustainable
economic activities and support the transition to a low-carbon economy.
Climate investing can take many forms, including investing in compa-
nies that are actively working to reduce their carbon footprint, investing
in renewable energy projects such as wind and solar farms, or investing in
innovative technologies that help reduce carbon emissions. A low-carbon
footprint means that the portfolio has a low exposure to carbon-intensive
companies. ‘Carbon intensity’ is a measurement of the carbon dioxide and
other greenhouse gases released annually by a company at a given time,
in relation to the revenue of the company. In other words, it shows how
carbon efficient the company is. Thus, a portfolio’s carbon intensity is a
weighted average of carbon intensities of companies which constitute the
fund.
In particular, the greenhouse gas accounting has grown in importance;
the industry has classified all emissions into three scopes:

1. Scope 1 emissions refer to direct emissions from sources that are

owned or controlled by a company. This includes emissions from
company-owned vehicles, manufacturing facilities, and other opera-
tions that are directly under the control of the company.
2. Scope 2 emissions refer to indirect emissions from the generation
of electricity, heat, or steam that is purchased by a company. This
includes emissions from power plants or other sources of electricity
used by the company, but not owned or controlled by the company.
3. Scope 3 emissions refer to all other indirect emissions that are
not included in Scope 2. This includes emissions from the supply
chain, employee commuting, and product use by customers. Scope
3 emissions are often the largest and most difficult to measure and
manage.

Understanding Scope 1, 2, and 3 emissions is important for ESG investors

because it provides a more comprehensive picture of a company’s envi-
ronmental impact. By considering all three scopes, investors can better
assess a company’s exposure to climate-related risks and opportunities,
and make more informed investment decisions. Companies that are
actively working to reduce their greenhouse gas emissions across all three
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 109

scopes are generally considered to be leaders in sustainability and may be

attractive investment opportunities for climate investing.

New Frontiers on Indexation

As can be easily understood, the asset management industry has promptly
declined the new principles of sustainable investment through new market
indexes. Going back in time, the first ESG index, the Domini 400 Social
Index (now the MSCI KLD 400 Social Index), was launched by KLD
Research & Analytics in 1990. The governance of the KLD 400 index
has historically been maintained by a committee that has acted on the
basis of considerations such as ESG, size, and sector weighting, as well as
the evolution of investors’ perspectives on ESG issues. Today, rather than
relying on a committee, the KLD 400 is governed by a transparent set of
quantitative rules that relate to ESG ratings, ESG dispute scores, targets
for related sector representation, and the handling of corporate events. It
is rebalanced quarterly and constituents are capitalisation weighted. With
a track record spanning over 28 years, the KLD 400 is widely cited in
the academic literature examining the impact of sustainable investing on
financial performance. The evolution of the KLD 400 illustrates how ESG
indices have led to improvements in ESG research, enabling the transi-
tion from committees that make qualitative judgements to ESG ratings
that support consistent and transparent index decisions. Among the first
SRI indices in chronological terms, the Dow Jones Sustainability World
Index is also worth mentioning: introduced in 1999, it includes 2,500
leading companies worldwide in terms of sustainability performance. The
FTSE Responsible Investment Indices include the Catholic Values Index,
the FTSE4Good indices, the Dow Jones family of SRI indices, and the
Calvert Social Index. The latter surveys 1,000 of the largest US companies
based on their social audit of four criteria: the company’s products, their
impact on the environment, labour relations, and community relations.
Today, there are over 1,000 ESG indices, reflecting growing investor
interest in ESG products and the need for metrics that accurately reflect
the goals of sustainable investors. As explained by iShares (2021), the
construction of an ESG index starts with the identification of a ‘parent
index’, which defines the universe of eligible companies that can enter
into the index. Second, screening is applied to remove companies from
the investible universe. Moreover, the investible universe must be identi-
fied, substantially through three main approaches. The first refers to the
110 E. BOLOGNESI

fact that several ESG indices use exclusive screenings with reference to,
for example, tobacco, firearms, or fossil fuels to avoid particular types
of companies. The second approach can be traced back to the concept
of ‘blacklist’, i.e., the exclusion of securities of companies that are posi-
tioned below a specific threshold (in the form of a score) from the point
of view of environmental, social, and governance responsibility. The third
approach is the one called ‘Best-in-class’ and therefore the selection of
stocks characterised by a better ESG score than the relative indexes of the
same sector or geographical area.
Moving to the choice of the components’ weights, in this case the
most common approach is cap-weighting: the result is that larger compa-
nies show the higher weights in the index compared to the smaller ones.
Another approach used in this context is equal weighting, which assigns
equal weight to all components regardless of size, while a third approach
is tilting, which overweights and underweights companies based on rules
related to a particular index metric. Also, in the case of ESG indices, peri-
odic rebalancing is an opportunity to incorporate the most current ESG
data.
Figure 7.3 shows a classification of sustainable investments, starting
from the first form of sustainable investments based on ethics. Ethical
investing is mainly based on the exclusion of specific investment themes,
such as weapons, tobacco, alcohol, and pornography. The indices
describing this type of investment are therefore based on the exclusion
of companies operating in these sectors. Faith-based investing aims to
select investments that align with their religious beliefs and values. Many
faith-based investment strategies focus on ethically and socially respon-
sible investment excluding investments that are deemed immoral. For
example, a Catholic investment approach seeks equity ownership in align-
ment with the moral and social teachings of the Catholic Church while
Islamic investing follows Sharia investment principles. Thus, indices repre-
senting faith-based investments are based on investors’ religious beliefs.
Focusing on ESG investing, the number and variety of indices is growing
over time. Some indices target companies showing the highest ESG-rated
performance in each sector of the parent index, or target companies
with positive ESG characteristics while closely representing the risk and
return profile of the underlying market. Finally, the most recent are the
indices associated with climate investing. These indices are designed to
enable investors to integrate climate risk considerations in their invest-
ment process or, in more detail, to pursue new opportunities, while
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 111

aiming to align with the Paris Agreement requirements of limiting global

warming to no more than 1.5 °C.
We proceed with an in-depth analysis of the characteristics of some
sustainable indices of the US stock market. In particular, we have focused
on the MSCI indices to allow for an easier comparison of each index
against a single parent index, the MSCI USA index. The first analyses
focus on the period 2013–2023, a time window in which climate indices
had not yet been launched. Table 7.1 shows the description of the selected
sustainable indices.
The risk-return profile of these indices can be observed in Fig. 7.4.
The graph shows a similar level of risk and a slight overperformance of
the following three indices: ESG Screened, ESG Focus, and the parent
index. Moreover, the riskier portfolio is the MSCI Catholic Values while
the worst performer is the ESG Leaders.
A further element of interest is the study of the tracking error, and
its volatility, of the indices with respect to the parent index. The aim, in
this case, is to verify which portfolios deviate the most, in composition,
from the traditional MSCI USA Index. Figure 7.5 shows these statistics.
In confirmation of the previous analysis, the indices most similar to the
overall US equity market are the ESG Focus and the ESG Screened while

SUSTAINABLE INVESTING

ETHICAL FAITH - BASED ESG CLIMATE

INVESTING INVESTING INVESTING INVESTING

Based on
Based on Based on Based on
Climate change
exclusions religious beliefs ESG integration
mitigation

INDEXING

Fig. 7.3 Sustainable investing and indexation (Source Author’s elaboration)

112 E. BOLOGNESI

Table 7.1 The sample of sustainable indices: description

MSCI KLD 400 SOCIAL Designed to provide exposure to companies with high
MSCI ESG Ratings while excluding companies whose
products may have negative social or environmental
impacts. It consists of 400 companies selected from the
MSCI USA Index
MSCI USA ESG Designed to exclude companies associated with
SCREENED controversial, civilian, nuclear weapons and tobacco that
derive revenues from thermal coal and oil sands
extraction or that are not in compliance with the
UNGC principles
MSCI USA CATHOLIC Designed to be aligned with the moral and social
VALUES teachings of the Catholic Church
MSCI USA ESG LEADER Target companies that have the highest ESG rated
performance in each sector of the parent index
MSCI USA ESG FOCUS Designed to target companies with positive ESG
characteristics while closely representing the risk and
return profile of the underlying market
MSCI USA ESG SELECT Designed to target companies with positive ESG factors
LEADERS while exhibiting risk and return characteristics similar to
those of the MSCI USA Index
MSCI USA CLIMATE Designed to enable investors to holistically integrate
CHANGE ESG climate risk considerations in their investment process
MSCI USA ESG CLIMATE Designed to address climate change in a holistic way by
PARIS ALIGNED minimising its exposure to transition & physical climate
risks and helping investors pursue new opportunities,
while aiming to align with the Paris Agreement
requirements of limiting global warming to no more
than 1.5 °C
MSCI USA Free-float weighted parent index

Source Author’s elaboration on MSCI reports

those that deviate the most are the ESG Select Leaders and the Catholic
Values.
The next step is the analysis of a sample composed also of two
climate indices, more recently launched by MSCI, namely the MSCI USA
Climate Change ESG Index and the MSCI USA Climate Paris Aligned
Index. In this case, the observation period is March 2021–March 2023.
The graph in Fig. 7.6 provides evidence of the tracking error statistics of
the entire sample of sustainable indices. We can observe that the tracking
error volatility of climate indices is significantly higher than indices based
on other sustainable investing themes. Furthermore, in the case of the
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 113

12%

11%

10%
Return (yearly)

MSCI USA
MSCI USA CATHOLIC VALUES
9% MSCI KLD 400 SOCIAL
MSCI USA ESG LEADER
MSCI USA ESG FOCUS
MSCI USA ESG SELECT LEADERS
8% MSCI USA ESG SCREENED

7%

6%
15.0% 15.5% 16.0% 16.5% 17.0% 17.5% 18.0%
Standard dev

Fig. 7.4 Risk-return profile of alternative sustainable indices (2013–2023)

(Source Author’s elaboration on Bloomberg data. Analysis based on weekly
returns)

2%

1%
Tracking error

0% MSCI KLD 400 SOCIAL

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% MSCI USA CATHOLIC VALUES
MSCI USA ESG LEADER
MSCI USA ESG FOCUS
MSCI USA ESG SELECT LEADERS
-1%
MSCI USA ESG SCREENED

-2%

-3%
Tracking Error Volatility

Fig. 7.5 Tracking error and tracking error volatility of sustainable indices
(2013–2023) (Source Author’s elaboration on Bloomberg data. Analysis based
on weekly returns)
114 E. BOLOGNESI

Climate Change ESG Index we can observe a significant outperformance

compared to the parent index.
Finally, we aim to verify that the tracking error of sustainable indices is
driven by the size and value factors. Thus, we run the Fama–French three-
factor model following the same methodology described in Chapter Four.
Also in this case, the observation period is March 2021–March 2023.
Table 7.2 presents the results. First, the Alpha coefficients are not signif-
icant, except in case of the ESG Focus with a negative sign, suggesting
an underperformance equal to 0.41% on a yearly basis. The beta coeffi-
cients (calculated against the parent index, the MSCI USA Index) suggest
a low beta nature only of the Climate Change Index. The SMB coefficient
presents different signs: positive and significant in case of Catholic Value
and Climate Paris Aligned, suggesting a tilt towards mid-caps. The coef-
ficient is negative and significant in case of Climate Change, suggesting
an overweight of large caps. Moreover, the HML coefficient, when statis-
tically significant, is positive suggesting a tilt towards growth stocks if
compared to the overall MSCI USA Index.
It should be emphasised that the results of the latter analysis suffer
from an observation window that is too short to be able to reach solid

7%

5%
Tracking error

MSCI KLD 400 SOCIAL

MSCI CATHOLIC VALUES
ESG USA UNIVERSAL ESG
3%
MSCI USA ESG LEADER
MSCI USA ESG FOCUS
MSCI USA ESG SELECT LEADERS
MSCI USA ESG SCREENED
1% MSCI USA CLIMATE CHANGE ESG
MSCI USA ESG CLIMATE PARIS

0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
-1%

-3%
Tracking Error Volatility

Fig. 7.6 Tracking error and tracking error volatility of sustainable indices
(2021–2023) (Source Author’s elaboration on Bloomberg data. Analysis based
on weekly returns)
 7 THE NEXT CHALLENGE: ESG AND CLIMATE INVESTING 115

Table 7.2 Comparison between sustainable indices

KLD Catholic ESG ESG ESG ESG Climate climate

400 values screened select focus leaders change Paris
social leaders aligned

Alpha 0.00 0.00 0.01 0.86 (0.41)** 0.02 792.49 3.00

(Ann)
Market 1.01*** 1.04*** 1.01*** 1.03*** 1.01*** 0.99*** 0.84*** 1.03***
Expo-
sure
SMB 0.03 0.09*** (0.01) 0.04* (0.00) (0.01) (0.18)** 0.25***
HML 0.05** 0.11*** 0.04*** 0.02 (0.00) 0.03 0.15** 0.24***
R 0.98 0.98 0.99 0.98 0.99 0.98 0.85 0.95
squared

Source Author’s elaboration on Bloomberg data. Analysis based on weekly returns. Observation
period: March 2021–March 2023

conclusions. Future research will focus on these aspects in order to be able

to identify the characteristics of these innovative investment opportunities
and their risk profile. Sustainable finance, and in particular that which
deals with climate risk mitigation, is still in its infancy but the change
underway is epochal given the convergence of the commitment of three
fundamental players for its development: regulators, investors, and the
asset management industry.

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 Index

A C
Active bets, 3, 10, 27, 29, 70 Capital Asset Pricing Model (CAPM),
Active ETFs, 4, 68–70 2, 3, 8, 11, 15, 16, 40, 41, 50
Active management, 3, 4, 23–25, Cap-weighting, 2, 11, 12, 16, 45, 46,
27–29, 34, 40, 56, 59–61, 63, 110
65, 66, 70 Carhart four factor model, 42
Active Non-Transparent (ANT) ETFs, Climate finance, 107, 108
69 Climate indexing, 111, 112
Alpha, 24, 25, 28, 36, 44–46, 63, 65, Climate investing, 5, 104, 106,
66, 114 108–110
Arbitrage Pricing Theory (APT), 16, Core-satellite strategy, 65
41
Asset allocation, 2, 49, 60
Asset management industry, 1–3, 5, D
8, 18, 25, 45, 74, 79, 80, 103, Disclosure, 5, 69, 82–89, 98, 99,
104, 109, 115 101–103, 105
Diversification, 2, 3, 14, 17, 18, 25,
46, 48, 53, 55, 60, 66
B
Behavioural bias, 3, 26, 36
Behavioural manager, 26, 36 E
Benchmark, 2–4, 8–10, 14, 23–25, Efficient Market Hypothesis (EMH),
27–29, 32, 40, 43, 49, 50, 60, 24, 27, 46, 59, 60
63, 65, 68, 70, 80, 99 Efficient-weighted, 18, 19

© The Author(s), under exclusive license to Springer Nature 125

Switzerland AG 2023
E. Bolognesi, New Trends in Asset Management,
https://doi.org/10.1007/978-3-031-35057-3
126 INDEX

Environmental Social and I

Governance, 5 Incentive scheme, 32–34
Equal-weighted index, 19, 45 Index construction methodologies, 2,
ESG disclosure, 5, 83, 84, 86–89, 100 9, 17, 20, 21, 43
ESG indexing, 109 Index design, 3, 18
ESG investing, 5, 74, 75, 80, 96, Index funds, 4, 56, 60, 61, 65, 70
103, 110 Internet bubble burst, 13
ESG ratings, 5, 96–98, 100, 101, 109
Ethical investing, 74, 110
EU Regulatory Framework, 104 M
European Green Deal, 88, 103 Market portfolio, 2, 8, 9, 11, 12, 16,
EU Sustainable Finance Disclosure 17, 40, 41, 43, 60
Regulation (SFDR), 80, 104, 105 Markowitz, H.M., 2, 8
EU Taxonomy, 104, 106–108 Minimum volatility-weighted, 18
Exchange Traded Funds (ETFs), 4, Momentum factor, 50, 51
46, 47, 56, 60–70, 80
P
Paris Agreement, 79, 84, 87, 103,
F 111
FAANG stocks, 15 Passive management, 4, 24, 25, 27,
Factor Indexing, 49 28, 40, 46, 60, 61, 63, 65, 70
Factor investing, 3, 4, 39, 40, 46–49,
53, 55, 56
Faith-based investment, 110 Q
Fama-French three factor model, 114 Quality factor, 52
Financial bubble, 12, 17
Fundamental indexation, 17, 50
Fundamental-weighted index, 44 R
Responsible investment strategies, 101

G S
Growth factor, 48, 49, 53 Short-terminist, 32, 34
Smart beta, 4, 46, 66–70
Socially Responsible Investing (SRI),
H 5, 74, 76
Herding behaviour, 29–32, 36 Sustainable finance, 74, 75, 77, 80,
High dividend yield strategy, 52 103, 104, 115
 INDEX 127

Sustainable indexation, 111 U

Sustainable investing (SI), 5, 74, 75, Underperformance, 28, 59, 114
87, 88, 96, 104, 109, 111, 112

T
Tracking error volatility, 9, 27, 70, V
112 Value factor, 44, 114