The Next Evolution in Index-Based ESG Strategies
By Willem Keogh, Head of ESG, Thematic and Factor Solutions, STOXX Ltd.
The growth of sustainable investing in recent years has been nothing short of spectacular, propelling this market segment from the fringe to center stage.
Those of us involved in the development of environmental, social and governance (ESG) investment approaches have been first-hand witnesses to the advancement of these strategies and the boom in assets behind them.1
Last November, STOXX introduced its first ESG version of a flagship benchmark, the STOXX® Europe 600 ESG-X Index, which follows standardized company exclusions based on norm- and product-based screenings. These exclusions are in line with the responsible policies of the world’s major asset owners.
The launch of the STOXX Europe 600 ESG-X Index and the listing of futures at Eurex tracking it was followed in May by the introduction of a full-fledged family of ESG-X benchmarks that covers the entire world. That family now includes a total of 43 indices, such as the EURO STOXX 50® ESG-X Index, the EURO STOXX® Banks ESG-X and the STOXX® USA 500 ESG-X Index.
According to STOXX research, light exclusions such as those in ESG-X indices do not materially affect risk-return performance relative to traditional market-capitalization-weighted indices.2
From old to new benchmark
The ESG futures listed on Eurex have facilitated trading and hedging of responsible portfolios and represented an important step in the construction and easy implementation of ESG portfolios. They have also helped bring down trading costs. By late June 2019, open interest in the ESG futures had grown to a nominal value of 678 million euros.
I expect that indices like the ESG-X suite will become benchmarks for many large investors and asset owners, as their fiduciary role increases and more regulation kicks in.
A second phase in responsible index investing
However, many investors need benchmarks that go beyond standard negative exclusions and that can measure or replicate an active strategy of incorporating ESG factors positively.
Thus, the world of ESG indexing will start moving from negative and norm-based screening — which I call Phase 1 of responsible index investment approaches — to a next stage that includes ESG integration and positive screening. That is, selecting and overweighting companies with the highest responsible credentials and underweighting the ESG laggards. This Phase 2 promises to lift the capabilities of index investing to new levels.
STOXX has taken the first steps in this direction with indices such as the EURO STOXX 50® Low Carbon Index and STOXX® Europe Climate Impact Ex Global Compact Controversial Weapons & Tobacco Index, both of which also underlie futures listed on Eurex.
ESG leaders can add to returns
Selecting stocks on metrics other than the traditional market-capitalization criteria means that returns may diverge from standard benchmarks more than if simply applying a number of exclusions. However, there is empirical proof that companies with higher sustainable records tend to outperform in the long run, therefore offsetting these concerns. The thinking is that these companies can better manage their reputational and idiosyncratic risks and run their operations more efficiently.
Since the early 1970s, around 2,250 academic research studies have been published on the link between ESG and corporate financial performance, according to a paper by DWS.3 Two thirds of the studies have found a positive correlation between the two variables, with only 8% finding a negative correlation.
As indices integrate ESG data into stock selection, their methodology can help investors incorporate science-based targets into their stock-picking and comply with regulation and recommendations. The advantage of having indices that comply with investor mandates will prompt more institutional asset owners to adopt them as their new benchmarks, as is already the case with ‘Phase 1’ ESG indices.
At STOXX, we are excited about new developments to be announced very soon in the ESG-integration and positive-screen index space. As we work on new solutions, our usual principles extend to ESG benchmarks: they need to be transparent, rules-based, and use best-in-class data providers.
Looking beyond current ESG strategies
Phase 3 of passive ESG investing will eventually be built up around two other pillars: those of socially responsible investing (SRI), or ethical investing, which considers both financial returns and social and environmental good; and that of impact investing, which targets Sustainable Development Goals (SDGs).
Sustainable investing has moved to the core of asset portfolios. Index-based strategies are facilitating this transition. They have built a strong base and are now evolving by taking in ever more comprehensive responsible approaches. This evolution will continue unabated, to the benefit of the broader world.
1 According to the Global Sustainable Investment Alliance (GSIA), assets managed under ESG strategies grew to $30.7 trillion at the end of 2017, from $22.9 trillion two years earlier.
2 STOXX Research, ‘STOXX® EUROPE 600 ESG-X Index – Analyzing ESG Exclusions,’ December 2018.
3 DWS, ‘ESG & Corporate Financial Performance: Mapping the global landscape,’ December 2015.
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