A Smarter Way to Increase Sustainability
Sustainable investing continues to gain momentum as an integral part of portfolio construction. According to the most recent data from the Global Sustainable Investment Alliance1 (GSIA), 30% of professionally managed assets globally employ ESG (Environmental, Social and Governance) strategies.
As such, high in investors’ minds is the premise of how to follow ESG principles without forgoing returns or increasing risk. Better yet, could an ESG strategy also lower volatility?
STOXX Ltd. has targeted that ideal scenario by introducing a set of indices that track companies with the highest sustainability indicators, but additionally put emphasis on those criteria that help lower single-stock volatility.
The STOXX ESG Impact indices draw upon three of seven widely used and recognized approaches to ESG investing that were covered in a recent PULSE ONLINE article accessible here. Namely:
- They apply a norms-based screening that selects only companies compliant with UN Global Compact Principles
- They run an exclusionary screening to remove companies in the coal-mining industry
- They conduct a positive screening based on a set of selected ESG key performance indicators (KPIs)
The last of these three points exposes the STOXX ESG Impact Indices to KPIs that have been detected to lower single-stock volatility. The indicators identified are:
1. Carbon emissions/energy reduction target
2. Percentage of independent board members
3. Percentage of women on board
4. Policies against child labor
5. Lack of large pay-outs on terminated executive employment
From the universe of STOXX® Global 1800 Index members, and of US companies in it, respectively, the STOXX® Global ESG Impact Index and the STOXX® USA ESG Impact Index are compiled based on the components’ exposure to the set of selected KPIs.
The stocks are then ranked and weighted based on their aggregated ESG score. For more on the indices’ methodology and composition process, click here.
According to Dr. Jan-Carl Plagge, Head of Applied Research, and Christoph Gackstatter, Product Development Manager, at STOXX, the way KPIs have been selected for the STOXX ESG Impact Indices forms a new approach to ESG investing.
“Most of the existing approaches to sustainable investing are agnostic to return and risk,” they wrote in a paper published in July and accessible here. “STOXX ESG Impact Indices, on the other hand, are constructed with a secondary objective in mind. The objective is to focus on those KPIs that have a risk-reducing influence.”
Risk and return
Empirical results indicate that, when controlling for other factors, companies selected into the indices show a negative exposure to risk relative to those selected into the respective benchmark (Figures 1and 2) over the entire time period observed.
Figure 1: Relative exposure to volatility factor and resulting cumulative performance contribution
for STOXX US ESG Impact Index [Oct. 2010 – Mar. 2016] in USD.
Figure 2: Relative exposure to volatility factor and resulting cumulative performance contribution
for STOXX Global ESG Impact Index [Oct. 2010 – Mar. 2016] in USD.
When looking at associated returns, the results further reveal that this negative exposure to volatility, as a by-product, translates into excess return.
On portfolio level, both sustainability indices’ risk and return characteristics have been similar to those of traditional benchmarks. As the table below shows, the STOXX ESG Impact Indices slightly outperformed their benchmarks over the period analyzed. Risk was lower for the STOXX USA ESG Impact Index, but slightly higher for the STOXX Global ESG Impact Index, something Plagge and Gackstatter attribute to other factors, such as stocks correlation. Maximum drawdowns were lower for both ESG Impact Indices.
Figure 3: STOXX, USD net return data from Sep. 17, 2010 to May 31, 2016.
In other words, sustainability principles do not have to compromise returns volatility. For both ESG Impact indices, the negative exposure tom risk was a large contributor to excess return.
FlexShares, an exchange-traded funds provider managed by Northern Trust, in July listed two funds tracking, respectively, the STOXX Global ESG Impact Index and the STOXX USA ESG Impact Index. This opens the door to the ESG Impact strategies for investors of all size.
Sustainable and responsible investing is attracting a growing pool of money as investors realize the fiduciary duty they have in shaping the world we live in. As interest grows, the investment community will welcome the marriage of sustainability principles and the traditional focus on risk-adjusted returns.
1Global Sustainable Investment Review, 2014, GSIA.
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