Many asset owners and investment managers would argue that sustainability-driven portfolios eventually need to be compared against mainstream benchmarks – and rightfully so. In a world where performance tops the agenda and trustees are increasingly challenged to cover their funds’ liabilities, investment decisions need to hold up against total market returns. This is equally true for any focus on a specific subset of financial markets – be it region, sector, size, style, or sustainability. Investors will always ask whether they should make a particular allocation to one, or more, of these boxes and whether – in hindsight – they made a wise decision. Total market indexes help them provide an answer.
Simultaneously, investors need tools to plan, implement and control the individual components of their asset allocation. If they brief an asset manager to invest exclusively into growth stocks, they will want to measure that portfolio against a growth index. Should they invest into emerging market bonds, they will compare their performance against the appropriate benchmark for this segment. And if they decide to allocate a portion of their assets into a sustainability-driven equity mandate, they will be looking for a sustainability index to implement this decision and to assess their manager’s skills.
The first benchmark accounting for environmental and social criteria was the Domini 400 Social Index. Launched in 1990, this US index excludes various industries such as alcohol, tobacco and firearms and applies additional thresholds on environmental impact, product quality and safety, diversity and employee relations to select companies. A different approach is taken by the Dow Jones Sustainability Indexes, launched in 1999. Based on the cooperation of Dow Jones Indexes, STOXX and SAM, these products marked an important milestone by providing the first global sustainability benchmarks following the best-in-class approach. Rather than screening out whole industries and applying negative selection criteria, the DJSI family is based on comprehensive sets of general and industry-specific indicators to identify sustainability leaders in each sector. In contrast again to this focus on best practice, the FTSE4Good indexes – set up in 2001 – aim to establish a minimum standard by including every company that meets certain criteria regarding environmental sustainability, human rights and stakeholder relations and that is not involved in a group of exclusion industries.
This diversity among the index providers mirrors the different sustainability approaches taken by investors and asset managers. Notwithstanding their distinct characteristics, all of these benchmarks fulfil three important functions: Firstly, they provide an essential tool to analyse the risk and performance of specific approaches to sustainability. Secondly, they allow for efficient implementation of sustainability mandates by applying the indexes as universes as well as through index-tracking portfolios. And finally, they offer a conduit for investors to jointly express their interest in sustainability and, thus, to collectively move the relevant issues up the corporate agenda.
The function of sustainability indexes as performance indicators is relevant in two areas. On the one hand, there is a growing demand among investors to scrutinise the risk/return characteristics of sustainability investments as a whole. Certainly, researchers can, and do, already use sustainability-driven funds and mandates to target this objective. However, these studies are rarely able to find out whether an out- or underperformance against the total market can be attributed to the application of sustainability criteria or to good timing and selection skills of the responsible asset managers. Indexes – being based neither on timing nor on stock picking beyond initial construction – provide the appropriate data to isolate the sustainability impact from manager skills. At the same time, specialised indexes are often needed to control the performance of sustainability-driven asset managers. If a manager is briefed to exclusively select stocks out of a subset of the FTSE Global Index, it wouldn’t be fair to compare his or her performance against the entire benchmark. An appropriate evaluation of investment managers matches the performance benchmark with the universe that the manager can choose from. Sustainability indexes provide the platform for that.
Specialised benchmarks also allow for an efficient implementation of sustainability briefs. Obviously, there are many different approaches that asset managers can apply to integrate economic, environmental and social criteria. Diversity will continue to shape the industry and provide an important impetus for constant improvements. Different needs and demands among investors will always be an important feature of the market. And divergent views about the “right” sustainability criteria will keep the debate lively and the development of proprietary selection methodologies firmly on the agenda. However, at the same time demand is out there – and growing – to use sustainability indexes as objective and cost-efficient universes that active managers can choose from. Rather than building up in-house research capabilities, a growing number of sustainability-driven active investors are thus choosing these benchmarks as their starting point for portfolio construction. Similarly, demand is out there – and rising – to apply the concept of sustainability within passive mandates. Again, indexes provide the basis for this option. With the rising amount of passive sustainability investments and the efficiencies of using established benchmarks as universes for active portfolios, the rationale for indexes in this field becomes increasingly obvious. They provide asset owners with the option to profit from the cost-efficiency of passive mandates while at the same time allowing them to apply the concept of sustainability. They allow the market to efficiently pool resources for the assessment of companies. And they eventually also offer active investors a yardstick to find out whether their managers with a proprietary methodology are adding or destroying value – net of fees – compared to the index-based alternatives.
Finally, sustainability indexes also meet the growing interest among investors and the wider public to move long-term economic, environmental and social issues up the corporate agenda. Investors and asset managers have two alternatives to achieve this goal. They can either directly engage with companies in which they hold shares or move their money behind an index that puts a spotlight on the issues they care about. Direct engagement is particularly relevant when the focus is on specific concerns. The Pharmaceuticals Shareholder Group’s “Investor statement on pharmaceutical companies and the public health crisis in emerging markets” is a notable example. Developed by ISIS Asset Management and the Universities Superannuation Scheme, this project provides a framework for institutional investors to jointly engage with pharmaceutical companies on access to patented medicines and the response of this sector to the public health crisis in emerging markets. Carrying the support of several investing heavyweights, the initiative has an influential voice within this focused debate. At the same time, the expanding amount of assets managed against sustainability indexes, turn these benchmarks into a growing incentive for companies to improve on a broader front. Today, over E2.8bn are managed against the DJSI family and public recognition of these benchmarks is quickly rising. As a result, firms are placing ever more importance on being a DJSI member and are seeing the indexes as an important driver to improve their sustainability performance.
Against this background, the use of sustainability indexes will continue to expand. The specialised offerings in this field will provide a growing number of investors and asset managers with objective and reliable benchmarks to move into this market. They will continue to support the rising professionalism within this segment by offering tools to analyse performance and implement mandates in a cost-efficient way. And they will offer an ever stronger incentive for companies to integrate economic, environmental and social criteria into corporate strategy and practice.
Alexander Barkawi is managing director of Dow Jones Sustainability Indexes in Zollikon-Zurich