Index funds and ETFs seem to be the flavour of the month with investors all around the globe, and the sustainability world is no exception.  Underpinning these investments, there are now close to 100 different green or sustainable indices, up from almost none five years ago, which track the financial performance of the leading sustainability-driven companies worldwide.

This wave of new products comes in part in response to retail demand for sustainable investment instruments, which have to be based on SRI benchmarks.  (Retail interest in SRI always increases when there has been a run of corporate scandals, such as fraud at Enron and Worldcom, third world sweat shops in Walmart’s supply chain … and now the failings at AIG, Lehman and other financial institutions).

 The availability of benchmarks is essential to institutional investors, such as public pension funds, which incorporate passive mandates as a significant part of their overall investment policy.  Indexing is a low cost strategy which requires relatively little monitoring and management on the part of the asset owner, and the use of specialised indices is seen as a relatively easy way to incorporate ESG factors into a passive mandate.

The most well established indices, which are widely tracked by institutional investors, tend to focus on Western markets.  For example, the Domini 400 Social Index, which is about to notch up its twentieth year of operation, is modelled on the S&P 500.  The FTSE4Good index series and Dow Jones Sustainability Indices also concentrate on developed markets, although some Asian-based companies have recently been included, such as Cathay Pacific and Hysan Development in Hong Kong.

In response to demand from investors for specialised indices, new products have been recently developed that focus on particular sustainability areas, especially climate change, water and energy.  One relatively early entrant was Standard & Poors, which operates the S&P Global Clean Energy Index, measuring the performance of 30 companies in the sector, and the S&P Global Water Index, which tracks 50 companies.  Meanwhile, as new industries develop - such as smart grid technologies or energy storage - growth-focused, cleantech indices have emerged, such as the WilderHill Clean Energy Index and the Cleantech Group’s Cleantech Index.

The growing availability of SRI indices in Asian emerging markets makes a vital contribution to the ability of local investors to develop policies on ESG investing. Institutional investors in these markets tend to be conservative, and to rely heavily on passive mandates. In many cases, they are constrained by government regulation from accessing companies included in overseas SRI indices, and have been unable even to consider these issues in the absence of an index of domestic companies.

Fortunately, these indices are now being being put together across the region, including S&P’s ESG India Index, RepuTex’s Sustainable China Index and China Governance Index and OWW Consulting’s SRI Index Singapore and SRI Index Malaysia.  This year, there have been a number of new entrants: the KEHATI-SRI Index was launched in Indonesia in June and the Shanghai Stock Exchange’s Social Responsibility Index started up in August.  Stock exchange regulators in Korea and Thailand are also working on creating indices for their markets.

These tools are helping to increase corporate transparency in emerging markets, and to enable investors, and companies, to benchmark their sustainability practices.  They also provide investors a way to measure returns on SRI investment, versus the wider market, without having to analyse the specific and varying methodologies of individual SRI funds.  Thus, the Dow Jones Sustainability World Index has dropped 29.51% since inception in August 1999 until the end of May this year, compared to losses of 30.74% for the MSCI World Index; while the Domini Social 400 Index has returned 8.50% from inception in May 1990 until the same period, compared with a gain of 7.77% for the S&P 500.

However, just as no two SRI funds are alike, competing indices also use different criteria in analysing and selecting their constituent companies.  Recent academic research has alleged that significant elements of subjectivity may be included in the analysis, and that some methodologies fail correctly to reflect the environmental and social performance of the constituents. 

Nearly all SRI indices depend heavily on voluntary reporting by corporations, either via public information or through regular surveys.  This has the potential to create size bias, as companies with greater resources can more easily handle such requests from the index compilers.  It could be argued, therefore, that such indices are highly likely to include a high percentage of large cap stocks - which leads some analysts to claim that some SRI indices outperform for precisely that reason, and not due to ESG excellence in their chosen companies!

In order to demonstrate that it is indeed the ESG factor that generates superior returns, SRI index providers need to be open about their criteria and methodologies.  Some indices provide detailed information on their websites and elsewhere, but many do not disclose the details of how they perform their analysis, and it is not clear how the effects of ESG issues are calculated and reflected.  Given that these indices require full disclosure from their constituent companies, it is not unreasonable to expect them to be equally open.

Nevertheless, while it is important to recognise that some SRI indices are more robust in their construction than others, they provide investors in emerging markets with an excellent entry point to SRI.  We can expect to see the emergence of a wide range of specialised index products, customised for Asian markets, in the years to come.