In 2018, the CEO of BlackRock announced their world’s largest asset management groups’ decision to stop investing in companies that do not comply with environmental, social, and governance (ESG) standards. A year later, the launch of the S&P 500 ESG Index, a stock market index aligning investment objectives with ESG values for the biggest companies in the US, confirmed a paradigm shift in the investment world towards strategic, long-term mainstream investments.
The long-term impact nature and multi-stakeholder approach of ESG in nature align with the increasing complexity companies are facing on a global scale amid an unfolding climate crisis, a growing population, and technologization. Back at its roots in the 60’s, social responsible investing served those who wanted to exclude certain stocks from their portfolio, such as arm trade or tobacco production. Along the way, frameworks for sustainable and socially responsible businesses such as the UN Global Compact and The New York Stock Exchange’s Principles for Responsible Investment laid down the foundation for ESG indices.
Fast forward to the present day, ESG assets are on pace to make up more than a fifth of total global assets under management in less than five years, growing much faster than the overall market.
Continue reading to learn more about how an ESG index is constructed and what are the benefits as well as challenges of ESG investing.
What is an ESG index?
Let’s start with the basics. A stock index indicates the attractiveness of a certain market by tracking the price performance of a pool of shares from companies in that market. An ESG index adds a layer of complexity to the selection of the companies in the pool, by taking into account additional criteria to market capitalization or stock trading liquidity. ESG criteria are aimed at tracking the performance of companies when it comes to their environmental, social, and governance practices.
Different ESG indices use different ranges of ESG factors and data sources leading to one of the biggest challenges with ESG that we will discuss later on.
How is an ESG index built?
The aforementioned S&P 500 ESG Index, for instance, seeks to offer similar information and return profile as the original S&P 500, while adding an improved composite ESG score to the selection criteria. As opposed to thematic indexes, it is quite broad and aimed as part of the core of an investor’s portfolio by targeting 75% of the S&P 500’s market capitalization. Much like other benchmarks, the index starts by excluding tobacco, controversial weapons, and companies that do not comply with the UN Global Compact. In addition, it excludes companies with S&P Dow Jones Indices ESG scores in the bottom 25%. The scores are based on data gathered by RobecoSAM through an annual evaluation of companies’ sustainability practices. In 2018, this resulted in 154 constituents of S&P 500 excluded from the S&P 500 ESG Index.
Another provider of ESG indices is MSCI Inc.. They offer over 1,500 equity and fixed income indices designed to help institutional investors with their ESG mandates. These range from the MSCI ESG Leaders Indexes, which select companies with the highest MSCI ESG Ratings to the MSCI Focus Indexes, which aim to maximize exposure to positive ESG factors, and to MSCI Climate Change Indexes, which aim to present the performance of a strategy that reweights shares based on the risks and opportunities associated with the transition to a low carbon economy.
How can an ESG index benefit investors?
In a nutshell, ESG indices aim to help investors assess and integrate ESG considerations in their investment process and portfolio, mitigating associated risks, but also tapping into higher performance yields over longer periods of time.
ESG-related risks such as greenhouse gas emissions and climate change, pollution, resources scarcity, inequality, or poverty indicate some of the largest threats facing the business environment, with potential significant impact on the companies’ performance, ability to raise capital, and even survive. On top of the potential for direct consequences of not dealing with these threats in their surroundings early on, companies are facing increased regulatory pressure from governments pushing a decarbonization transition agenda to mitigate risks at a social and economic level. Thus, it’s no surprise ESG has become a top priority for most business leaders, as well as investors.
In a recent survey, nine of ten asset managers said they believe that by integrating ESG into their investment strategy they will obtain overall higher returns, while 60% already reported higher yields.
MSCI data also indicates that high-ESG-rated companies historically have higher valuations, higher profitability, and lower idiosyncratic volatility.
What are the current challenges in ESG investing?
Despite their potential to support investors, the effectiveness of using ESG standards to drive business activity and investment has recently come under intense scrutiny. Challenges include mixed data about ESG funds’ performance, complex regulation, the lack of transparency and consistency in ESG data sources, and the lack of standardization across ESG rating frameworks.
A research paper from 2019 analyzing the Morningstar sustainability ratings of more than 20,000 mutual funds in the US, indicated that although the highest-rated funds in terms of ESG attracted more capital, none of the high ESG funds outperformed any of the low-rated funds. Then in 2022, amid a global economic turmoil triggered by a global pandemic and the invasion of Ukraine which saw oil prices skyrocketing, ESG indexes underperformed worldwide as a result of an outperforming energy sector, MSCI reports.
Furthermore, despite increased efforts on the side of rule-setting and reporting, studies have found that companies added to ESG portfolios don’t always subsequently improve compliance with environmental or governance regulations. Nor has the signing of pan-European frameworks such as the UN’s Principles of Responsible Investment necessarily lead to an improvement in their ESG scores, HBR reported.
One challenge has been the lack of consistency and transparency behind ESG data, leading to an abundance of ESG-related terminology and, in turn, of ESG-focused benchmarks available for index providers. Some ratings derive from qualitative data, while others use quantitative data. Then, not all industries and companies report all data, leaving rating agencies to fill the gaps with estimates. These differences have created confusion about what the true ESG score of an asset should be, and a mislabeling of products as ESG.
Detractors also justify ESG underperformance on account of the movement having created an incentive for companies to make false claims. Due to increased interest in ESG, companies and investors are under a higher pressure to publicly embrace ESG-related practices to attract more clients. They may fall short, however, when it comes to eventually providing evidence for their claims, which is known as greenwashing.
In the near future, standardizing ESG criteria such as through the recently adopted EU Corporate Sustainability Reporting Directive is expected to reduce confusion, mislabeling, and the risk of greenwashing, and help index providers and investors better navigate the ESG landscape.