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Special Report

Impact investing


Indices of awareness

As interest in socially responsible investment (SRI) continues to grow. Index providers have responded by creating ethical equity indices that allow investors to target only those companies with a clean record, morally speaking.
But the central problem with ethical stock indices is that morality is subjective. Can morality be defined? If philosophers and theologians have debated this issue for centuries, surely index providers have little chance of having a solution to suit everyone?
Dow Jones launched its Sustainability indices more than three years ago. The set includes the Dow Jones Sustainability World Indexes, which include the leading 10% of companies in terms of sustainability out of the biggest 2,500 companies in the Dow Jones Global Index, and the Dow Jones Stoxx Sustainability Indexes, which include the top 20% from the Dow Jones Stoxx 600 Index.
The FTSE4Good Indices were established at the end of July 2001 as tradeable and benchmark indices containing leading companies from the FTSE All-Share Index. The FTSE4Good selection criteria cover the areas of environmental sustainability, developing positive relationships with stakeholders and upholding and supporting universal human rights
Apart from these indices there is the Domini 400 Social Index in the US, created by social research firm Kinder, Lydenberg, Domini, which is based on the S&P 500. In Sweden is an index created by Etikanalytikerna which excludes companies that have breached the international convention of human rights or environmental conventions as recognised under Swedish law, and French firm AReSE launched SRI indices last autumn in France.
The E Capital Ethical Index Euro was launched in May 2000 by independent financial adviser E Capital Partners. The index includes 150 stocks from a universe of European stocks listed on recognised exchanges across Europe. Stock selection is ratified by a largely Roman Catholic committee.
At least in the UK, ethical investment is one of the fastest growing areas of retail investments. Now, some £4bn (e6.5bn) is invested in ethical funds, and the number of funds has increased greatly since the end of the 1980s, says Scott McAusland of the Ethical Investment Research Service (EIRIS).
And in 1999, a law was passed which ensures that all pension funds state in their statement of investment principles what approach they are taking on SRI, he says.
Alexander Barkawi, managing director of Dow Jones Sustainability Group Indexes, says interest in the indices is growing rapidly. This interest has come from the institutional side as well as the retail investor environment.
“We see a growing number of institutions who are interested in the subject, and also in using the concept for passive investment. That’s a very important point where our indices come in.”
Dow Jones selects companies to be included in its sustainability family by starting with a universe of 2,500 companies, says Barkawi. The companies are then analysed and a ‘best-of-class’ approach used. “We seek to have the best in each industry,” he says. This avoids the potential problem of excluding certain industry sectors altogether – such as the oil industry and other ‘sin industries’. Excluding such industries can create difficulties for investors that have a duty to diversify across all sectors.
The ethical investment market is moving towards a more positive approach, says Barkawi, where leading companies in each industry group are identified. “This meets the demands of institutional investors who need diversification and who would be very hesitant to exclude whole industries and deviate from their benchmark,” he says. Dow Jones selects the top 10% in each industry.
Who decides whether a company has sufficient moral high ground to be included in an SRI index? FTSE says it uses a separate committee of SRI experts, including people from both academia and financial institutions. This committee worked to put together the rules for the FTSE4Good indices. The methodology, it says, is fully transparent and has been constructed according to market demand. FTSE’s index is far more comprehensive than Dow Jones’. In March FTSE announced that a further 82 companies had met the criteria for inclusion, which means that over 80% of companies in the FTSE All-Share are now represented in the FTSE4Good.
Paul Grimes, chief financial officer of FTSE Group, says there is significant interest in the FTSE4Good indices, both from the investment community and the constituents themselves. Companies are paying more attention to corporate social responsibility (CSR) issues, partly because they seek to be included in SRI index such as FTSE4Good, he says.
While the sustainability indices seek to include representative companies from all major sectors under current the FTSE methodology, certain categories of company are excluded. These are tobacco producers, firms involved with nuclear weapons and nuclear power, for example.
After this, the companies have to meet at least three of the CSR criteria. The FTSE4Good family includes eight indices in all – a UK index, US index, European index and global index, with each of these available as a retail and a benchmark index.
But is ethical investment simply too subjective to be neatly defined by a broad index? Dan Fox, analyst at Commerzbank, thinks this is a central problem with all SRI indices. “In the long run, it’s going to become difficult to say that one company is an ethical one and another is not,” he says. “For example – are companies doing genetic research unethical or ethical?” He predicts a proliferation of sub-indices, but doubts whether the products have much of a future.
Guy Fisher, analyst at ABN Amro, says there is no real agreement on what is ethical and what is not. “Institutions who are interested in this tend to look at it themselves on a stock-by-stock basis, so it’s difficult to see them needing an index,” he says.
In cases where an institution is running an ethical portfolio, its benchmark should be the FTSE All-Share, he says. However, ethical indices are probably needed for institutions running a tracker fund, he says.
Barkawi agrees that SRI is a complex issue, with much disagreement over what exactly constitutes an ethically sound business. This is why it is vitally important that providers of socially responsible indices lay their methodology open for the world to see. “You must be fully transparent with what you do,” he says.
“It’s always very difficult to meet everybody’s requests,” says Grimes from FTSE. But FTSE has come up with what it believes is a balanced methodology to represent the general agreement. The sustainability indices do allow flexibility to account for investors’ specific ethical requirements . “We definitely meet demand where certain countries are to be excluded,” he says. The methodology makes it possible for ‘sustainability-specific’ indexing, Dow Jones says, for example, excluding tobacco, alcohol, armaments, or all three.
FTSE, too, says it can be flexible. If an institution has particular demands, FTSE can create a customised benchmark to take account of these demands, he says.
Despite the problems of creating an ethical index that suits a broad enough section of the investment community, Noel Grant, senior investment consultant at Watson Wyatt, says the SRI indices now available have already fulfilled a crucial function. “What I think is useful, is to have some fairly high profile coverage of SRI indices. If they do raise awareness, that is a good thing.”
Jane Ambachtsheer, senior consultant at William Mercer, says that even though public interest levels in the new ethical indices have been high, her consultancy has not seen much take up of these benchmarks. “A lot of fund managers are completely down with these selection criteria,” she says. Some indices take an exclusion approach, but it is difficult to do this on behalf of a broad-based institution. “Very specific institutions will exclude very specific industries where they know their members will be in agreement with that,” she says. “But as soon as you come to a broad-based group of shareholders from different walks of life, it becomes very difficult to choose which stocks should stay and which should go.”
Ethical indices – such as they exist – are probably not the immediate solution for pension funds right now, says Ambachtsheer. “But it’s another option in the market place and it signals that this index development is here to stay,” she says.

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