An index is a group of companies that reflect the performance of a certain sector. Thus an ESG index includes companies that meet certain criteria for environmental, social, and governance standards and reflect that sector.
Just as a large-cap equity index like the S&P 500 can be used as a performance benchmark for the performance of large-cap U.S. stocks, different ESG indexes can be used as benchmarks for sectors focused on sustainable or socially responsible investing (sometimes called SRI) practices.
Some indexes may also include or exclude companies as a form of risk mitigation.
The challenge is that the criteria for what constitutes sustainable investing, in any form, is inconsistent throughout the industry.
Nonetheless, recent industry research suggests that ESG investing strategies perform similarly to, and sometimes better than conventional strategies. By knowing some of the top ESG indexes, then, it’s possible to invest in funds that capture the performance of that index, and put your money toward companies whose aim is to focus on positive environmental, social, and corporate governance outcomes.
What Are ESG Indexes?
There are a number of ESG indexes maintained by major data providers which track the performance of firms that embrace ESG or SRI criteria. Why are environmental, social, and governance factors considered important enough to be the foundation of dozens of industry indexes?
Some investors believe in investing their money in the stocks of companies (or other securities) that reflect certain proactive values regarding the planet, society, and fair and ethical corporate structures. At the same time, adherence to ESG factors is increasingly 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). Consumers 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 (aka passive investing).
Just as there are many different flavors of equity indexes — from large cap to small cap, domestic to international, and so on — there are numerous ESG indexes. These exist in many forms, depending on the underlying metrics used to construct them, and there are hundreds of ESG index funds and ETFs that investors can access.
Recommended: How to Invest in ESG Stocks
New Growth in the ESG Sector
According to Deloitte, some 149 ESG-related funds were launched in 2021 alone, making up 22% of all funds launched by managers in that year.
The number of ESG-related funds on the market continues to grow, roughly a third of them passively managed index funds or ETFs. In 2021, socially responsible U.S. mutual funds saw record inflows of some $70 billion — a 36% increase over 2020. However, ESG funds saw substantial outflows through 2021 and most of 2022. But sustainable funds still managed to outperform non-sustainable funds through Q3 of 2022, despite challenging market conditions, according to Morningstar research as of September 30, 2022.
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 universally observed 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 funds, and the manner in which they’re constructed.
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 specified ESG criteria established 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.
2. Nasdaq-100 ESG Index
The Nasdaq-100 ESG Index consists of 96 separate securities that meet ESG criteria established by Nasdaq. 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 the following requirements, at a minimum, to qualify under the index:
• “An issuer must not be involved in certain specific business activities, such as alcohol, cannabis, controversial weapons, gambling, military weapons, nuclear power, oil & gas, and tobacco.”
• “…an issuer must be deemed compliant with the United Nations Global Compact principles, meet business controversy level requirements.”
• “…have an ESG Risk Rating Score that meets the requirements for inclusion in the Index.”
3. MSCI KLD 400 Social Index
Established in 1990, the MSCI KLD 400 Social Index is one of the first and oldest socially responsible investing (SRI) indexes, making it a popular standard for evaluating long-term ESG performance.
The KLD 400 Social index comprises 402 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.”
4. MSCI USA Extended ESG Focus Index
The MSCI USA Extended ESG Focus Index includes securities across the U.S. equity markets, but selects constituents from the MSCI USA parent index using an optimization process that targets companies with high ESG ratings in each sector. Companies related to segments such as tobacco, controversial weapons, producers of or ties with civilian firearms, thermal coal and oil sands are excluded.
The MSCI USA Index has 628 constituents while the MSCI USA Extended ESG Focus Index has around 321, which means an exclusion close to 49%.
5. FTSE US All Cap Choice Index
The FTSE U.S. All Cap Choice Index is part of the FTSE Global Choice Index Series. It’s designed to help investors align their investment choices with their values, by selecting companies based on the impact of their products and conduct on society and the environment., but excludes companies involved in:
• 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
Risks and Drawbacks of ESG Indexes
As with all investments, the risks of choosing ESG-linked investments is that they may not necessarily outperform over your target timeframe. There are also unique ESG-linked issues that come with evaluating these indexes.
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 capitalization (“cap”) weighted, which means that the largest firms in the index bear the greatest responsibility for changes in index values.
Given that some of most popular ESG investments also track the performance of the broader-market indexes, this makes these particular indexes less attractive as part of a diversifying strategy.
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 inconsistent reporting among industry firms, 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; whether these metrics are actually relevant to the underlying investments can be debated. 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, some ESG-linked funds have introduced an additional factor to correctly weight relevance of certain criteria. However, 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.
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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