Incorporating ESG considerations into portfolios is clearly a growing priority for many investors today. Whether driven by regulation, investment beliefs or values — investors are increasingly asking how their indexed or passive investments can adapt to new realities.
Index managers have broadened their toolkits and are able to offer portfolios that no longer just capture the wider market but that have specific objectives, such as efficiently incorporating ESG criteria.
So, how can index managers help investors futureproof their portfolios?
First, a word about performance. In a recent paper1 we looked at a number of studies that measured the performance in shares globally over the recent COVID19 crisis period and beyond, and found that there was significant outperformance related to high-scoring ESG stocks over the periods studied.
An HSBC study2 measured the share performance of over 600 public companies globally and found that climate-focused stocks outperformed others by 7.6% from December 2019 going into the crisis period and generally high ESG-scoring shares beat the others by about 7%.
In another study, Morningstar3 found that sustainable and ESG equity indices outperformed conventional indices in the Global, Europe and US Large-Cap categories in the month to March 2020.
In other words these studies suggest that the right ESG-aligned portfolios can provide good downside protection and a useful uptick in performance.
Now, let’s go on to consider the four key ways that ESG criteria can be successfully incorporated into index portolios.
Screening Out to Improve ESG Profile
Investors make wide use of exclusions to keep their ESG incorporation simple and manageable. In fact, out of the $30+ trillion in global ESG-labelled assets,4 the majority were in exclusionary screens, either norms- or investment-led.
In Europe, exclusion still represents more than 50% of total ESG assets,5 even if approaches such as integration and best in class have been growing at a faster pace.
The Returns Question
For many investor the question arises: am I harming my return potential by excluding companies from my investable universe? A 2017 paper from MSCI6 seems to suggest that some level of exclusions are not harmful to performance. In fact, it may even be moderately positive if those exclusions are concentrated on the worst types of corporate wrongdoing.
Also, larger companies do seem to be impacted more by negative events. Investors that use market-cap-weighted indices, where allocations to companies are determined by their size, should be particularly mindful of that.
Getting the Exclusions Right
An important consideration for any investor is how the exclusion list should be defined. While screening may sound relatively simple, the process involves a significant amount of judgment on the part of the asset manager and/or their investors, and potentially the data provider with whom they partner to conduct the screening.
We believe that to be optimal, a screening process should have the following characteristics:
be systematic and transparent;
be aware of the potential impact on an investors’ risk and return objectives;
be consistent but not inflexible; and finally
leverage best-in-class data. This may necessitate using multiple providers.
We see exclusions as a straightforward way for investors to remove securities that could potentially be damaging to performance because of reputational risk (worst offenders) and/or changes in regulation/consumer preferences.
2 Best In Class
Improving the ESG Characteristics of a Given Exposure
In a best-in-class approach, one is looking for an improvement in the ESG characteristics of a given market or exposure. This approach will tilt the portfolio towards companies with higher ESG scores and away from the weaker scorers.
The rationale here is not only to reduce risk (by tilting away from poor scorers) but also to potentially enhance returns (by tilting towards high scorers). There is an underlying belief that companies with better ESG scores will deliver better returns over the long term. Research7 has shown that improved performance can be operational, at cost of capital level and share price.
In this approach, investors will ultimately have a portfolio that has a higher ESG score than their initial investable universe. To do that, indices need both ESG scores and a portfolio construction approach that will differ from standard market cap-weighted methodologies.
The Importance of Scores
There are many different providers of ESG scores and this can lead to confusion, especially when — as is often the case — scores differ. Investors need to do their own due diligence and understand what are the key methodological choices that underpin a specific approach.
We have identified three primary points of differentiation:
Which factors/metrics are material for an investor to determine a company’s future financial performance?
Data Acquisition and Estimation Use of different sources (Where does the data comes from? How is that data is acquired?) and different estimation methods (How do they overcome data gaps?)
Aggregation and Weighting Each data provider has developed proprietary methods to aggregate and weight ESG metrics in order to derive their summary scores.
Despite the data challenges, we are seeing an increase in demand for best-in-class approaches as investors become more comfortable with research results and the number of available solutions increases. From a practical implementation perspective, this approach can used to tilt either standard indexed or smart beta approaches.
Focusing on Specific ESG Themes
Thematic approaches allow investors to be more granular in terms of the ESG improvement or goal they target. Here, the investment is focused on specific themes. This approach has grown in popularity as investors increasingly seek to align their portfolios with their convictions or to have a more immediate impact on specific topics.
There’s a wide variety of themes that can be targeted by investors in passive or indexed portfolios. Currently, we’re seeing great demand for climate and carbon indices, but investors are also looking for indexed solutions that address wider societal concerns such as the UN Sustainable Development Goals, health products and human rights.
Another Dimension of Success
Thematic approaches move the discussion from the pure risk/return spectrum to frameworks which include other measures of success. When considering these approaches, investors will need to think about how their oversight and governance may change, in order to fully capture the desired outcomes. For example, they may transition from simple additional reporting (Is my carbon footprint lower than before?) to more qualitative (Is my strategy influencing change at the right level within an organisation?)
The Final Evolution
As ESG considerations grow evermore present in investment decisions, ultimately integration will be at a level that we are no longer talking about ESG per se. All investing will be ESG investing. ESG metrics will no longer be considered to be an additional, discrete (and at times optional) input but will be part-and-parcel of all investment decisions.
At this point, it would not so much be that ESG would be considered an option for a passive or indexed investor, but rather that ESG data would be an explicit means to generate alpha in an active approach. The idea here is that investors can make better investments by incorporating financial and non-financial/ESG data in their decisions.
Sourcing quality data will be key, given that selecting securities based on quantitative and qualitative assessment of ESG factors, requires analyst expertise. As data disclosure improves in breadth and consistency, managers will have a broader, and better, set of inputs at their disposal.
There are many routes to effectively incorporating ESG considerations into indexed portfolios. In fact, through indexing, investors have more flexibility to incorporate their own views and possible constraints compared to more active strategies.
Thinking to the Future ESG consideration is no longer optional for most investors and it makes sense to begin a structured journey towards increasingly incorporating ESG into portfolos. The good news is that index managers have a wider toolkit than ever before and can work with investors to better shape their allocations, help them through the decision process and identify what is the most suitable ESG approach for their investments.
1 COVID-19 and ESG: Four Dimensions, Carlo Funk, SSGA 2020.
2 ESG stocks did best in COVID-19 slump, Ashim Paun (2020).
3 How ESG ETFs Have Performed in the Sell-Off, Briegel Leitao (2020).
4 GSI, 2018 Global Sustainable Investment Review
5 Eurosif, European SRI Study, 2018
6 MSCI, Have corporate controversies helped or hurt performance?, Journal of Environmental Investing 8, (2017
7 Clarck, Feiner, and Viehs, From the Stockholder to the Stakeholder – How Sustainability Can Drive Financial Outperformance, Arabesque Partners (2015)
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