The past 18 months has seen a dramatic rise in the popularity of Responsible Investment, and a major part of this rise has been the emergence of Environmental, Social and Governance (ESG) indices and funds tracking these indices.  So, are they the future of Responsible Investing, or will their success prove to be fleeting?

ESG indices, like any other indices, are rules-based products, designed to allow investors to track the index, either for comparison purposes, or to facilitate investment funds based on replicating the index.    Instead of seeking to capture the whole of a given market, ESG indices apply environmental, social and governance criteria to that market to arrive at a subset of that market which meets the stipulated ESG criteria.  This can be done by employing exclusion criteria, such as avoidance of tobacco, armaments, fossil fuels and gambling; or an ESG tilt where weightings of holdings are adjusted to favour stocks with better ESG practices.  They can also focus on specific metrics, like gender equality or carbon footprint, to tilt a portfolio toward companies with better performance in these areas.  Finally, an ESG index can also be constructed by requiring that each stock in the index meets certain criteria such as a threshold on revenues from chosen activities like clean technology or renewable energy. These are highly thematic in nature and enable pure exposure to these themes.

Whatever ESG rules are applied, the same principles are applied as for traditional indices in that weightings of stocks in the index are determined by market capitalisation of the securities, with rebalancing being undertaken on a regular basis.  ESG indices also share the same attractions, since they allow funds to be run in a low-cost way that replicates the market they are designed to track.  These attractions have led to a surge of ESG passive funds replicating a myriad of ESG indices and the reasons for this are not hard to fathom – clear rules, low charges and reduced stock-specific risk.  These are all attributes that lend themselves to successful long-term investment and pension funds in particular.  ESG indices have therefore been applied to multiple asset classes including equities, bonds, infrastructure and real estate.

Yet, like any rules-based system, the rules really matter and its vital to understand how the rules are applied. Where thresholds are applied, what does that threshold allow and what does it exclude?  What criteria are applied and do these meet the concerns of the individual investor?  Where ESG scores are applied, who determines the scores and are they accurate?  More fundamental questions also need to be answered: do funds that operate on ESG principles result in any positive social and environmental outcomes or are they more about doing a little bit less harm?  And just because a company falls within a theme, it doesn’t mean that the company doesn’t do any harm.  Active investors tend to consider companies in a more rounded sense, looking at the operational practices of the company as well as the nature of their products and services.  They also engage with investee companies to improve their social and environmental practices, something that is typically notable by its absence in passive funds.

We therefore regard ESG indices with a healthy degree of scepticism, whilst recognising that passive funds based on these indices can form a valuable part of a portfolio where the rules meet the needs of the investor and deliver positive social and environmental outcomes.  Indices based on ESG scoring are riddled with complexity and debate on the validity of the scoring, but funds based on more focused ESG indices are worthy of consideration.  For example, the Lyxor Green Bond ETF invests in bonds where 100% of the money is dedicated to positive environmental outcomes, and unusually for an ETF, the fund reports on these outcomes in a clear and comprehensive manner.  Whilst the transparency and scope of this reporting is currently unusual for a passive fund, it may point the way for the future.  We are still at the early stages of the development of ESG products, so it might be expected that they will continue to evolve with more ever-increasing diversity and range.  This will make it more important than ever to fully understand exactly what you are investing in and what the indices don’t cover as much as what they do.  One thing is for certain – ESG indices will form an increasing part of the investment universe and can’t be ignored, but neither so they sound the death knell of thoughtful active funds that will always allow the nuances of Responsible Investment to be more fully reflected.

Blog Written By: John Fleetwood

Pennine Wealth Solutions LLP, authorised and regulated by the Financial Conduct Authority and only available through authorised Financial Advisers.

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