ESG as a Performance Factor for Smart Beta Indexes

Although traditional financial factors, such as value, growth, and momentum, have become common practice in the construction of smart beta indexes, the question whether environmental, social, and governance (ESG) data can be used as a performance factor in a similar way is a controversial topic in the asset management community. In this article, the authors develop a methodology to extract an unbiased standalone ESG performance factor from a broad database of ESG indicators and apply this ESG factor in different smart beta type of index methodologies. The results show that this ESG factor can add financial value in portfolios and financial indexes and can be used the same way as or in addition to traditional common performance factors.