As data-driven ESG investing soars, understanding how indices are formed will become increasingly important, reports Tom Higgins.
Environmental, social and governance (ESG) themed investing has undergone a rapid transformation in recent years, rising to prominence on the back of investor demand.
Research from Bloomberg Intelligence suggests that global ESG-linked assets are set to exceed $53 trillion (£37.5 trillion) by 2025 – more than a third of all assets under management.
Behind the scenes, ESG indices – the tools that benchmark companies’ ESG credentials and performance – are developing and proliferating rapidly, providing investors with a huge range of options for benchmarking their strategies. Coupled with an abundance of technological improvements, and with plenty more on the horizon, ESG indices have become essential benchmarks for how the ESG and sustainable investing market structure is defined.
Carlo Funk, head of EMEA ESG investment strategy at State Street Global Advisors, wrote in a recent paper on index investing and ESG themes that increasing transparency and improving reporting techniques could mean that investors “transition the core of their portfolios to sustainable index investments”.
What will it take for pension schemes to make that transition?
Dealing with data
For pension scheme trustees, understanding how these indices are constructed and how providers interpret data is imperative to ensuring their effective use. Understanding their shortcomings and limitations can also prepare pension schemes to navigate any future difficulties.
“Sustainable investing incorporates an analysis of the opportunities and risks associated with certain ESG issues that may be overlooked in the traditional investment process,” says Jessica Robinson, author and adviser on sustainable finance and responsible investing at Moxie Future.
“For ESG indices, companies are scored on both the exposure of the company to the ESG issues and the ability of the company to manage these exposures.”
Such indices aim to support institutional investors to identify investment opportunities that can facilitate hitting certain sustainability outcomes. These can include specific benchmarks weighted to companies that are reducing greenhouse gas emissions or attempting to improve diversity on boards or in the workforce. Most indices, however, use a broad set of criteria across each of the three pillars of ESG.
For the rapid expansion of ESG investing to succeed, accurate and relevant data will be crucial. Currently, information relating to environmental impacts or social criteria is far less easily available than traditional financial data. Even data points that are established – such as those relating to carbon emissions – are not always comparable.
The many and varied ways that different providers have sought to address these data issues have led to more than 1,000 different indices coming on to the market, each with a differing methodology, process and end result.
Louisiana Salge, impact specialist at EQ Investors, says that there is no set way to build an ESG index, nor one type of data that is used. The common ground between all benchmarks is how they are constructed around a defined objective – an element that sets the tone for the rest of the framework.
For institutional investors, understanding the rules governing an index’s construction will help ensure that it, and any strategies aligned to it, is a good match for the overall objective. Investors should also scrutinise the data used and the methodology for interpreting it.
“Without that,” Salge says, “you cannot seriously claim that you understand the sustainability characteristics that an index is targeting.”
How it’s done
How can trustees be sure that a particular index or ESG rating approach is right for their investment strategy and aligned with their principles?
There are several different types of players to be aware of when seeking to understand the construction of an ESG benchmark. There are the organisations setting reporting standards, the data processing and analytics houses that attempt to make sense of the reported information, and the benchmark providers themselves.
Standard-setters such as the Global Reporting Initiative and the Sustainability Accounting Standards Board aim to improve the structures in place to facilitate ESG reporting. Their standards outline how to achieve accuracy, completeness and clarity in disclosures, which in turn improves the quality of information being fed into the next stage.
Specialist data firms such as TruValue Labs use unprocessed data to gather further insights, using sophisticated artificial intelligence (AI) technology to sift through large and complex datasets. Other firms scrape data from online sources, such as news websites and social media. Data gathered this way is often specialised and can be used to meet the specific requirement of an index’s methodology.
Ratings agencies, including RobecoSAM and MSCI, collate this data to rate companies according to a broad assessment of their ESG credentials. These ratings are used by the index providers – often this can be the same company as the rating agency, such as S&P or MSCI – to construct a universe of companies.
As ESG investing – and associated data analyses and reporting – has become more sophisticated, more variations of benchmarks are emerging. These can be tilted towards highly rated companies, or exclude low-rated companies altogether. Indices can also be specialised in certain fields such as renewable energy, or themes such as climate change.
For those looking to align their portfolios with the United Nations’ Sustainable Development Goals (SDGs), there are many specialist indices and associated products. For example, TrackInsight’s database of exchange-traded funds (ETFs) lists 316 funds aligned to different SDGs, almost all of which are ‘passive’ strategies replicating a benchmark. These include ETFs tracking clean energy, gender equality, and clean water benchmarks.
Apples and oranges
At each stage of the data handling process, different organisations apply their own methodologies and interpretations. This can make ESG ratings – and in turn the indices they power – hard to compare directly. When formulating a score for a company, MSCI’s method involves 37 factors across 10 themes. S&P, meanwhile, relies on 23 criteria, while FTSE Russell has 14 themes. Investors often voice frustration that ratings can differ quite dramatically from one provider to the next.
However, this may not necessarily be a bad thing, argues EQ Investors’ Salge.
“While it is indeed true that correlations are lower than one would expect, different data providers have developed unique scoring methodologies that differ on purpose,” she says. “Sustainability is complex, and naturally there is not just one way to analyse the sustainability of a company, and how this relates to financial risks and opportunities.”
Rather than focus on the lack of correlation between disparate indices, Salge says trustees should focus on “digging into the differences in methodology”. Schemes should look to align with the data provider and the indices that best match their objectives and principles.
The rate of change within the indexing industry is expected to be rapid. Not only do ESG indices sit at the perfect crossroads of booming demand and increased capital flows, but the technology used to drive the systems will continue to develop, with AI and machine learning becoming more widely integrated.
Some providers are already exploring how to bring forward-looking metrics into their analysis and product development, based on the real-world impact of companies and assets. For pension investors, this could help match ESG goals to liabilities.
Salge adds: “Carbon data input and ESG rating methodologies are among the most developed forms of sustainability data sets that can be used for index construction, but the same sophistication does not exist in rating companies on their ‘impact’ on real-world outcomes.”
Moxie Future’s Robinson agrees that tailoring will be an “important component” of how ESG indices look in the future.
ESG indices are not just found in the equities space, either. There are many fixed income benchmarks with an ESG focus constructed in a similar way, while GRESB is an international body working on reporting and benchmarking standards for the real estate investment sector.
Relying on ESG ratings and indices involves significant due diligence to ensure that methodologies used to compile the data and benchmarks match the viewpoint of the investor. As regulation drives pension schemes to embed ESG considerations within their investment processes and long-term strategies, understanding the components that make up their sustainable allocations will be increasingly important.