ESG benchmarks galore

The five myths

ESG is officially mainstream, now that the largest money managers in the world are adopting new ESG policies, excluding certain industries and beefing up their ESG teams. The most prolific of these ESG policies for passive managers is a switch to one of the literally thousands of ESG benchmarks. And in response, index manufacturers are constructing more and more ESG indices, resulting in the growth of ESG indices far surpassing the growth of normal indices. But are there downsides to these ESG indices? In this article we will address the 5 myths of ESG benchmarks.

MYTH 1

BY DEFINITION, COMPANIES IN AN ESG BENCHMARK ARE UNIVERSALLY SUSTAINABLE

ESG benchmarks are plentiful nowadays, each with a different implementation of sustainability frameworks. The focus can vary from scores on environmental, social and governance (ESG) factors to low carbon and other niches in that space. If all these subject and sustainability niches had a universal definition, all index funds tracking any ESG benchmark could be classed as “sustainable”. However, in contrast to, for instance, bond rating agencies like S&P and Moody’s, where ratings are highly correlated, there is a material inconsistency among ESG ratings from different index providers.

Correlations of ESG ratings agencies’ scores across a common sample of companies

* Sustainalytics. Source: MIT Sloan School of Management

Even when you would expect that having a low carbon footprint couldn’t be open to interpretation and should be a single universal figure, this is not the case. Carbon footprints differ, due to different estimation techniques. The same holds true for scores in traditional ESG criteria, due to a) differences of interpretation or b) the perceived importance of one of these subjects and the weighting it’s given in an overall score.

Furthermore, ethical standards can differ among ESG benchmark providers. A good example is differences in defining business activity screens before companies are added to an index. Specific business activities of a company and its percentage of revenue derived from them are being defined in order to decide whether a company is excluded or not. We might take tobacco, for example, which is a common field where sustainability indices agree not to include tobacco producers in their index. And even though tobacco as a field is about shares, the tobacco-derived revenue levels that result in exclusions vary, from 5 or 10% for instance. One difference is, for instance, the definition of controversial weapons. Within methodology documents, the Dow Jones sustainability indices do not mention biochemical weapons as an exclusion criterion, whilst FTSE4Good mentions excluding controversial weapons, including biochemical weapons. As long as there is room for interpretation by ESG data providers and/or benchmark providers, definitions matter. This might mean that one ESG benchmark and its constituents might not achieve the sustainability criteria you set as asset owner or asset manager.

MYTH 2

ALL ESG RISKS ARE REDUCED/MITIGATED WHEN SWITCHING TO AN ESG BENCHMARK

In general, Index investors are focused on reducing their risks; investing in the full market reduces risk on individual stocks. Excluding companies does not necessarily mean that the idiosyncratic risks on stocks increase, as diversification is still created due to investing in a big enough subset of the market. If the index for instance consisted of 10 stocks, then this would be a problem, but that is almost never the case. The case for ESG benchmarks is that in addition to active risk reduction via diversification, the risks related to ESG are also reduced or mitigated.

* Nestle is a top 10 holding for the FTSE4Good developed market index, while it has been under immense scrutiny due to its supply chain management, price fixing and child labour.
https://research.ftserussell.com/Analytics/FactSheets/temp/dd18eed4-889a-46fb-b2eb-e8c38f57e407.pdf

The worst ESG rated companies in a particular sector are excluded or underweighted and the top get a higher weighting, all the while keeping close to the broad market benchmark with respect to country and sector weighting. Great, right? Well, this so called “best in class” methodology only goes so far, because there are cases where even the highest rated companies in a particular sector face significant ESG risks. The most obvious example is the oil industry. All oil companies are facing increased scrutiny relating to new rules and regulations arising from climate change. Therefore, would it make sense only to exclude the worst companies and keep the rest in your portfolio? Even if they are acting and addressing transition to a sustainable society by investing a portion of their capital in renewable energy, the risks they face are still significant. Most of the general ESG indices do not take this into consideration. So yes, ESG risks are reduced, but only partly!

MYTH 3

ESG BENCHMARKS SHOULD REQUIRE A PREMIUM DUE TO THE EXTRA FEATURES

Index providers are smart: with most of the same product, they can charge more, especially when ESG and SRI is involved. Index providers mostly charge extra for an ESG index; all the while the underlying methodology will stay the same, but with fewer stocks. The argument can be made that the premium is justified by the intellectual property that the index providers provide to their clients. A common process or universe selection can be determined amongst index providers.

MSCI World vs MSCI World SRI

Source: https://www.msci.com/documents/10199/149ed7bc-316e-4b4c-8ea4-43fcb5bd6523 and https://www.msci.com/documents/10199/641712d5-6435-4b2d-9abb-84a53f6c00e4

The main intellectual property of index providers lies within the universe selection – the first step of constructing an ESG index. Starting from the main benchmark, a number of selection criteria are used to exclude and include constituents, ending up with an investable universe which is weighted mostly using some form of market cap weighting. The selection of companies can be divided into 2 broad steps.

The first is the exclusion of “common” bad guys, meaning the ones that are excluded on the basis of, for instance, non-global compact or industry standards (such as tobacco). The index provider does not create a whole lot of added value with this step.

The second is the only step of real added value, namely the exclusion/inclusion of companies based on their proprietary ESG scores. The thresholds are determined by the index provider, therefore this is their IP that they provide the client. Finally, a weighting scheme is used to create the index, but apart from smart ESG indices, this is a common market cap weighting which is easily replicable. But all things considered, the extra work put in by the index provider does not warrant an increased fee on an ongoing basis, where the fee is based on the assets under management.

In short – is the fee justified? Doubtful. Is it smart way of doing business for the index providers? Definitely!

MYTH 4

SWITCHING TO AN ESG BENCHMARK NOW WILL MAKE ME READY FOR YEARS TO COME

For a lot of asset owners, switching to an ESG benchmark is quite an ordeal. It means that they need to come to terms with ESG in general, which means that they need to believe that ESG shouldn’t necessarily detract from performance whilst the number of companies in the investment universe is declining. Also, switching benchmarks for a passive fund will result in trading costs, which as an asset owner you don’t want to incur too often (thus switching benchmarks is preferably kept to a minimum).

Construction of typical ESG index

Source: PRI

And if ESG standards were stable at this point in time, switching to an ESG benchmark now would indeed make you ready for years to come. The caveat to this scenario is the parabolic rise of interest in ESG investing from both investors and regulators, as well as public opinion. ESG standards evolve rapidly; the European Commission, for instance, is working on definitions and requirements for EU climate transition benchmarks and EU Paris-aligned benchmarks.

Another example is the EU taxonomy on sustainable investments, apart from other industry initiatives such as science-based targets. This means that switching to an ESG benchmark, whichever one it may be, will drop you behind the curve in 6 months' or a year's time. And even in this context, index providers are opportunistically trying to align their offerings with the changes or proposed changes in regulations. Despite the volatile environment of regulations, index providers such as MSCI and ISS are launching that they call provisional climate change benchmarks, proactively launching benchmarks that will satisfy regulations (or so they guarantee). Which would imply that their current ESG benchmarks do not satisfy these new rules. This shows the eagerness of index providers to compel existing and potential clients to use their ESG type of benchmark. It also shows that due to the new rules and regulations, the definitions and standards of sustainability are fluid and can make current ESG benchmarks outdated within a couple of years.*

MYTH 5

ESG BENCHMARKS ARE THE ONLY TRUE WAY OF IMPLEMENTING SUSTAINABILITY IN PASSIVE FUND RANGES

Even if all the concerns about ESG benchmarks were accepted, it does not mean that tracking such a benchmark would be the only solution to the implementation of sustainability in passive investment processes. First of all, even when tracking an ESG benchmark, voting and engagement would be implied. For years, voting and engagement have been the way of implementing sustainability frameworks in passive fund ranges.

Another alternative to tracking an ESG benchmark would be to move to a tailored solution for passive mandates, where cooperation between asset manager and asset owners is still required to construct a custom ESG benchmark. For an asset owner with its own sustainability framework and requirements, a custom index is constructed through the implementation of this framework by an index provider… In this process, the ESG requirements and the index most likely fit perfectly, but using a proprietary ESG index as a benchmark comes with its own caveats.

ESG data index costs

Source: Opimas

First of all, as already mentioned, the costs of the index will most likely increase due the additional requirements and work for the index provider. Furthermore, as an asset owner, the index provider needs to be monitored on its work, which should align with the ESG framework of the asset owner, and should not be up to the interpretation of the index provider. Additionally, if the ESG framework is implemented with direction from the asset manager and if the index provider is responsible for further construction of the framework and implementation, the asset owner is giving away a lot of control to the index provider.

The latest development has been that asset managers and asset owners are moving towards a different model, stepping away from ESG or custom indices and implement their own systematic (passive) strategies that implement in-house ESG policies, while still tracking the broad benchmark. This development does mean that there is more deviation from the benchmark, due to the ESG companies that are excluded in the portfolio but not the benchmark. This results in an increased tracking error, which measures the standard deviation of returns from the portfolio and the benchmark. And although feeling more like an active strategy, the increased tracking error means that the alternative (an ESG benchmark), would also have additional tracking error compared to the broad benchmark. And because of the full customization options within investment strategies, agility increases, and legislative changes can be implemented quicker and by incremental steps without switching to a completely new tailor-made benchmark.

Conclusion

In short ESG benchmarks have a number of caveats, whether it be the differing definitions of sustainability, implementation of sustainability in the benchmarks resulting in hidden risks and the lack of a definite uniform framework for the long run. What we see is that ESG is becoming mainstream. Asset owners and managers that already are further ahead might move ahead towards custom indices, with more insight in topics they might find important. They create their own version of a benchmark in collaboration with an index provider.

And asset owners and managers with true ESG conviction implement ESG in their investment processes using broad benchmarks. This results in portfolios that have more relative risks towards the broad market (more tracking error), but with definite views on ESG key issues and sectors (sector deviation) with the adaptivity and ownership on the process.

As for ESG benchmarks, the current surge of acceptance and adoption of ESG in investment processes worldwide is key for the development of ESG benchmarks. And although it sometimes seems that ESG has matured, it’s still a somewhat novel topic for a big portion of investors. For early adopters of responsible investing ESG benchmarks may already be a thing in the past, for the rest of the investment community it is an easy fix for a novel problem.


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