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Nina Röhrbein reports on a recent surge in demand for sustainable indices, but questions whether they match client needs

Over a decade ago, there were only a handful of sustainability indices available to investors. But as environmental, social and governance (ESG) investments grew, so did related indices.

ESG indices are used for two reasons - passive investment, and to prove that a specific portfolio is better than the market.

Remy Briand, global head of index and ESG research at MSCI, has seen an increase in passive investing over the last 20 years. “When we look at the ESG dimension in passive indexing investors essentially want to achieve similar objectives as on the active side,” he says. “Some indices are used to create a best-in-class portfolio for socially responsible investment (SRI) funds, while others screen out certain companies.” Often pension funds actively screen indices but still want to have passive portfolio management.

Many believe that indices have played a significant role in improving company behaviour by pushing sustainability up the agenda.

“A lot of companies now link their remuneration to becoming, and remaining, part of an ESG index,” says Rodrigo Amandi, director of SAM Indexes. “The indices also provide investors with a powerful engagement platform.”

According to Amandi, the financial crisis prompted investors to go back to basics, such as benchmark investing. “We used to have a lot of structures based on the indices but currently have none,” he says. “Instead, investors buy into vanilla benchmark products.”
ESG indices are generally not constructed to be an alpha machine. Instead they are designed to give exposure to the concept of sustainability.

“Our ESG indices aim to at least capture beta,” says Alka Banerjee, vice-president, global equities, at S&P Indices. “In the last couple of years, however, we have seen some alpha too.” One example is the S&P India ESG index.

Outperformance of broader, non-thematic ESG indices tends to be more difficult to assess as their performance may be driven by different biases. Recently capital inflows have focused on thematic indices for clean energy or water. Another trend has been emerging markets.

The report ‘Assessing and Unlocking the Value of Emerging Markets Sustainability Indices’ by Esty Environmental Partners on behalf of the International Finance Corporation (IFC) found that ESG indices in emerging markets fall into three broad categories: rankings of the best sustainability companies against specific criteria, classic best-in-class structures and tilted plays.

“Sustainable indices are being launched in emerging markets as a cost-effective investment vehicle to identify the most sustainable companies,” says David Lubin, chairman at Esty Sustainability Network. “But they also improve the local sustainability framework by acting as a signalling mechanism to companies.”

The Esty study revealed that out of 19 emerging markets indices, 15 are country-specific, two regional and two global. Only two are carbon-efficient indices. Carbon indices have become popular in developed markets, but so far have had a mixed reception. Carbon is an agreed value driver for the future but many investors believe the research and data on carbon is not mature enough to facilitate efficient carbon tools and indices.

“A methodology on how to construct a carbon footprint is not yet on the table,” says Hervé Guez, head of SRI research at Natixis Asset Management. “The problem is finding the rationale behind, for example, a decline in carbon emissions. It could be due to a change in business model, falling sales or a reduction in carbon emissions. The idea is interesting but it is too early to simply rely on indices for carbon-footprinting. You still need a qualitative approach judged by geography and history.”

As there is not a standard approach to ESG, a lot of investors find that customised ESG indices better reflect their approach.

“Customised indices are a rapidly growing area for us,” says David Harris, director of responsible investment at FTSE Group. “As institutional investors understand ESG better, different pension schemes want to take slightly alternative approaches, particularly when planning to integrate ESG across all of their assets. This often means focusing on a particular subset or blending different approaches.”

Natixis AM is one investor that does not approve of the methodologies behind existing ESG indices. “The main problem we have with existing indices is that they are based on best-in-class comparisons within sectors,” says Guez. “We have a pragmatic, non-cynical approach in that we want to invest in the best-ranked companies of the investment universe rather than a sector.” Natixis AM hopes to have a customised ESG index by year-end. “The purpose of a customised index for us is to use it as a reference point in communication with clients,” says Guez.

The main problem with the available indices is a lack of clarity. With most existing ESG indices, investors currently do not know what they are buying because the index methodology is neither open nor transparent, according to Banerjee. Investors are also often left in the dark about risk and return profiles, while the data used for index composition tends to lack systematic and scientific analysis.

“Index operators have to be clear about how they define sustainability and assess companies’ ESG performance, whether it is focused on reducing risk or driving business upside,” says Lubin. “Investors have to be able to understand index goals and determine if that index matches their ESG objectives.”

“Providers also need to state what they are trying to achieve with the index,” says Euan Marshall, global product leader for sustainable investing at IFC. “Do they want to send a signal to companies in a particular market or do they want to create an investable product? It is unlikely to see institutional investors benchmarking ESG unless they have a sizeable passive allocation. If they do, they are more likely to move to a enhanced beta styles such as tilted plays.”

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