What Is an ESG Index? 5 ESG Indexes to Know
An ESG index consists of companies that meet certain criteria for environmental, social, and governance performance. An ESG index can be used as a benchmark for companies in that industry, region, or sector, just as a large-cap equity index like the S&P 500 can be used as a benchmark for the performance of large-cap U.S. stocks.
The challenge in most aspects of ESG or sustainable investing, including the construction of different indexes, is that most ESG standards are voluntary and can be inconsistent in the criteria and metrics they use to evaluate companies’ progress toward ESG goals, or mitigate ESG risks.
Nonetheless, recent research suggests that ESG investing strategies perform similar to conventional strategies. By knowing some of the top ESG indexes, then, it’s possible to invest in funds that track the performance of that index, and put your money toward companies whose aim is to focus on positive environmental, social, and corporate governance outcomes.
Key Points
• An ESG index consists of companies that meet criteria for environmental, social, and governance standards.
• An ESG index may also exclude certain companies or sectors (e.g. fossil fuels, gambling, adult entertainment) or those with low ESG scores.
• An ESG index can be used as a benchmark for securities in an industry, region, or sector.
• There are some 50,000 sustainability-oriented indexes, according to Morningstar.
• Owing to inconsistency around ESG criteria and metrics, it can be difficult to evaluate companies’ progress toward ESG goals, or compare one company to another.
What Are ESG Indexes?
An index is a selection of companies that reflect the performance of a certain industry, region, or sector. There are thousands of indexes, and they are constructed as benchmarks of the performance of that part of the market: e.g., large-cap companies, tech companies, pharmaceuticals, consumer goods, and so forth.
An ESG index focuses on companies that meet certain environmental, social, or governance standards. There are some 50,000 sustainability-oriented indexes, according to Morningstar. There are broad-based indexes as well as specific indices that focus on a certain industry, region, sector: e.g., renewable energy, water-treatment, carbon management, and so on.
Some ESG indexes may exclude companies that don’t match typical ESG criteria. For example, some ESG indexes exclude companies that manufacture certain types of weapons, are involved in gambling, or produce fossil fuels.
ESG indexes have become more common as investor interest in ESG investing strategies has grown.
Reason for ESG Indexes
Some investors believe in investing their money in the stocks of companies (or other securities) that reflect proactive values regarding the planet, society, and fair and ethical corporate structures. At the same time, adherence to ESG frameworks is considered by many stakeholders as a form of risk management.
For example, investors might choose to assess a company’s ESG scores or ratings to gauge its risk exposure (as well as possible future financial performance). Whether they invest online or using a brokerage, investors might want to know about a company’s environmental and social practices to inform their purchasing decisions.
While you cannot invest in an index, investors can gain exposure to ESG companies in an index by purchasing an index mutual fund or exchange-traded fund (ETF) that seeks to replicate the performance of that index (a.k.a., passive investing).
There are hundreds of ESG index mutual funds and ETFs that investors can access.
ESG Criteria Explained
Although there isn’t a single set of ESG criteria investors can use to measure where companies stand in light of ESG goals or risk factors, it’s useful to know what different ESG scores and metrics are referring to.
Environmental Factors
The environmental component of ESG includes factors that impact the natural environment. These can be general, or tailored to specific industries, and may include:
• Water, air, and other pollutants (e.g., toxic waste)
• Hazardous waste management
• Carbon emissions and mitigation efforts
• Water conservation
• Renewable energy use (such as solar, wind, biofuels)
Social Factors
The social component evaluates a company’s relationships to employees, vendors, and the surrounding community. Factors may include:
• Worker safety
• Diverse hiring practices
• Employee pay and equity
• Corporate investment in the community
• Relationships with vendors
• Supply chain management (fair labor use, sustainable sourcing, etc.)
Governance Factors
Governance refers to ethics and transparency in how a company is managed. For example:
• Selection of board of directors
• Executive compensation
• Transparency toward shareholders
• Accounting practices
• Data privacy
Recommended: How to Invest in ESG Stocks
Mixed Growth in the ESG Sector
The ESG sector is still seeing some growth, although not as robust as in recent years. According to Morningstar, global ESG fund assets rose to $3.3 trillion in Q3 of 2024, from $3.1 trillion in Q2 ‘24, and roughly $2.8 trillion YOY, as of September 2024.
Yet ESG fund outflows in 2024 were the highest they’d been since Morningstar Sustainalytics started tracking them in 2015, at $19.6 billion, topping 2023, which saw outflows of $13.3 billion.
Also, the number of new ESG funds that were launched in 2024 was around 10, compared with more than 100 in 2021 and 2022 566 in 2023.
ESG vs Socially Responsible Investing: What’s the Difference?
There are various terms for investing according to a certain set of values — including impact investing and socially responsible investing (SRI) — and not all of them refer to green investing strategies. Some terms may be used interchangeably, but there are some key differences to understand.
• Impact investing is a broad term that encompasses investors who seek measurable outcomes. Impact investing may or may not have anything to do with environmental or social factors.
• Socially responsible investing is also a broader label, typically used to reflect progressive values of protecting the planet and natural resources, treating people equitably, and emphasizing corporate responsibility.
• Securities that embrace ESG principles, though, may be required to adhere to specific standards for protecting aspects of the environment (e.g. clean energy, water, and air); supporting social good (e.g. human rights, safe working conditions, equal opportunities); and corporate accountability (e.g. fighting corruption, balancing executive pay, and so on).
ESG Investing Standards
That said, there isn’t one universal set of criteria that define an ESG investment or an ESG index. Rather, each ESG index and corresponding index fund is typically based on proprietary metrics of qualitative and quantitative factors relating to environmental, social, and governance factors.
These metrics may be formulated internally by investment managers/research teams, based on metrics established by popularly accepted ESG frameworks, or a combination of both.
While it’s clear where the money’s been trending with regards to ESG investments, prudent investors should still remain selective when it comes to picking an ESG fund, as how these indexes are constructed can sometimes be based on opaque methodologies.
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5 Commonly Used ESG Indexes
Following is an overview of five ESG indexes commonly used as benchmarks for some of the largest ESG index mutual funds.
1. S&P 500 ESG Index
The S&P 500 ESG Index consists of 307 domestic investments across the broader market. All firms included in the index must meet ESG criteria specified by S&P Dow Jones Indices.
ESG Criteria: According to S&P, the index uses an exclusionary methodology to filter out firms within the S&P 500 that partake in undesirable business activities, defined as follows:
• Firms operating within the thermo coal, tobacco, and controversial weapons industries.
• Companies that score within the bottom 5% of the United Nations Global Compact (UNGC).
• Companies that score within the bottom 25% of ESG scores within each global GICs industry group.
For more detailed information on the construction and constituents of this index, see the S&P 500 EDG methodology.
2. Nasdaq-100 ESG Index
The Nasdaq-100 ESG Index consists of securities from the Nasdaq 100 that meet ESG criteria established by Nasdaq and Morningstar Sustainalytics. The parent index includes 100 of the largest domestic and international non-financial firms that trade on the Nasdaq exchange.
ESG Criteria: Firms must meet a number of requirements to qualify under the index. These are determined by an exclusionary screening process by Nasdaq, that removes companies based on environmental, social, and good governance criteria.
The constituents of the Nasdaq-100 ESG Index are further refined by criteria developed by Morningstar Sustainalytics. These include a number of standards and metrics:
• ESG risk ratings
• Impact metrics
• Global standards screening
• Carbon emissions data
For details on all the criteria used to select companies in this index see the Nasdaq-100 ESG Index Methodology.
3. MSCI KLD 400 Social Index
Established in 1990, the MSCI KLD 400 Social Index is one of the oldest socially responsible investing (SRI) indexes, making it a popular standard for evaluating long-term ESG performance.
The KLD 400 Social index consists of 400 U.S. securities that meet the ESG standards set by the MSCI ESG Research team.
ESG Criteria: MSCI uses the following methodology to determine eligibility and inclusion within the index.
• Companies involved in nuclear power, tobacco, alcohol, gambling, military weapons, civilian firearms, GMOs, and adult entertainment are excluded.
• Must have an MSCI ESG rating above “BB.”
• Must have an MSCI Controversies score above “2.”
For more detail on the criteria used to select companies in this index, see the MSCI KLD 400 Social Index methodology.
4. MSCI USA Extended ESG Focus Index
The MSCI USA Extended ESG Focus Index selects constituents from the MSCI USA parent index using an optimization process that targets companies with high ESG ratings in each sector.
Companies that meet “business involvement criteria” in sectors such as tobacco, controversial weapons, producers of or ties to civilian firearms, thermal coal (and other fossil fuel companies), are excluded from the index.
The MSCI USA Index has 589 constituents while the MSCI USA Extended ESG Focus Index has around 284, which means an exclusion of about 52%.
For more detail on the criteria used to select companies in this index, see the MSCI USA Extended ESG Focus Index methodology.
5. FTSE US All Cap Choice Index
The FTSE U.S. All Cap Choice Index is part of the FTSE Global Choice Index Series, which is market-cap weighted. The index uses a rules-based methodology to exclude companies based on their involvement in business areas that could have a negative impact on the environment and/or society.
• Vice-related industries (e.g. alcohol, tobacco, gambling, adult entertainment)
• Non-renewable energy (e.g. fossil fuels, nuclear power)
• Weapons (conventional military weapons, controversial military weapons, civilian firearms)
• Companies are also excluded based on controversial conduct and diversity practices
For more details, please see the FTSE Global Choice Index series methodology.
ESG Investing Risks
As with all investments, the risks of choosing ESG-focused investments is that they may not necessarily outperform over your desired timeframe. There are also unique ESG risk factors to consider.
Diversification Risk
The primary risk of using an ESG-based strategy is the risk of underperformance and the risk of reduced diversification relative to cheaper, broader-market index funds.
This isn’t a surprise, as many of the top ESG indexes are market-cap (“capitalization”) weighted, which means that the largest firms in the index bear the greatest responsibility for changes in index values.
Given that some of the most popular ESG funds also track the performance of the broader-market indexes, this may make these particular funds less attractive as part of a diversified strategy.
Higher Costs
Another issue of concern is that some ESG funds charge higher fees and expense ratios relative to conventional funds.
While these fees aren’t necessarily head and shoulders above broader-market index funds, they can get progressively more expensive depending on how nuanced the fund’s investing strategy is. This is because ESG is a factor-based investment strategy which entails more complexity than traditional broader-market indexing.
Typically, the longer the time frame for comparison, the greater the risk for underperformance becomes, net of fees.
Inconsistency of ESG Standards
Perhaps the biggest drawback of ESG investing is the inconsistency around reporting, and the desire for more uniformity among which ESG frameworks are applied.
In other words, the ESG criteria established at one institution for their index or funds has little or no bearing on the ESG criteria employed by another firm.
Because sustainable investing has grown over the past decade, there has been an industry-wide movement towards greater consistency in ESG criteria and reporting. The Securities and Exchange Commission (SEC) has even recently undertaken efforts to codify aspects of financial reporting when it comes to ESG-related investments.
Nevertheless, these efforts remain in their early stages, and investors should continue to be discerning when it comes to picking ESG-linked investments.
Relevance of ESG Criteria
Existing ESG frameworks run the gamut when it comes to which metrics they choose to apply. For example, metrics related to carbon emissions may be relevant to heavy industry, but how relevant would those metrics be to the financial or technology sectors?
To address the issue of relevance, individual investors would do well to identify and assess when these solutions are applied.
Finally, expect to encounter data consistency issues when trying to quantify information that is naturally qualitative, particularly when management at each firm has wide discretion over how they choose to represent those metrics.
Benefits of ESG Investing
Some investors may be drawn to the potential advantages of ESG investing.
Investing With Values in Mind
Although it’s unclear whether ESG strategies make a tangible difference in the health of the environment, the well-being of society, or whether these strategies improve the quality of corporate governance, many investors appreciate the ability to invest in companies that espouse these values.
Moreover, as ESG strategies continue to expand, investors may choose from an even wider range of sustainable options that may align with their values: e.g., companies that support women, people of color, that focus on specific types of bio-techology, and so on.
Comparable Performance
As noted above, ESG strategies have come a long way in terms of assuaging investors’ fears of underperformance, or missing out on market returns.
While any strategy is subject to market volatility, and there are no guarantees of future performance, recent industry research suggests that ESG strategies perform comparably to conventional strategies over time.
Risk Management
Owing to the rise of climate-related disasters, worldwide viruses, and similar shared risk factors, companies must take new steps to protect themselves from these risks. Today, many ESG metrics take risk mitigation efforts into account.
The Takeaway
There’s no doubt that enthusiasm for ESG investing has grown over the past decade, and continues to gain traction. Understanding ESG indexes and how they apply sustainability rules and criteria to the companies in the index can help investors understand the corresponding index mutual funds and ETFs they may want to invest in.
Due to the sheer number of ESG-centric investments available to date, it’s a good idea to be selective when reviewing the underlying strategy of each fund, and understanding the underlying methodology of how each index constructs its portfolio.
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FAQ
What are the main components of ESG investments?
The main factors involved in ESG investing are how a company’s operations and products impact the environment (e.g., air, water, land, and other resources in the natural world); society (workers, community members, other stakeholders); and the overall governance of the company itself (e.g., its leadership, accounting practices, security measures).
How do ESG investments differ from traditional investments?
In order to be considered a type of ESG-focused investment, a company or security must meet certain standards in terms of the environment, society, and or its governance. These criteria are not generally applied to traditional or non-ESG securities.
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