How index providers are thinking about ESG

We are heading in the direction where there is going to be an ESG variant for every traditional index, says Reid Steadman, Managing Director, Global Head of ESG, S&P Dow Jones Indices

Sara Benwell POSTED ON 9/6/2021 5:50:57 PM

Fund Operator: What have been the most defining trends that you have seen in ESG investing? How popular have indices been relative to other methods of investing in ESG?

Reid: ESG indices were previously viewed as niche benchmarks up until just a few years ago, when we saw this segment come to the forefront. It accelerated greatly in the past two years, driven by individuals and institutions wanting to align their values and investments, as well as the desire for new ESG indices that targeted the core of investment portfolios.

"We are seeing increasing ESG integration into more mainstream and popular benchmarks and indices"

Many of the early generation indices were developed with a very narrow focus or used a more thematic approach. Today, we are seeing increasing ESG integration into more mainstream and popular benchmarks and indices such as the S&P 500.

We launched the S&P 500 ESG Index in early-2019, whereby ESG factors and scores are integrated into the core benchmark. Investors and financial product providers use this index not only to measure ESG performance, but also as a building block to create index-based ESG investing strategies such as ESG exchange-traded funds.

Fund Operator: What criteria is being used to construct ESG indices and how many different “flavours” (e.g. industry-focused, regional- focused) are available to investors?

Reid: The breadth is now quite wide. Ultimately, we are heading in the direction where there is going to be an ESG variant for every traditional index. There are going to be different flavors of ESG indices that sit alongside the more mainstream ones.

There are indices broken down according to E, S and G factors. The most developed part of this is currently the E component, which has a large audience. In line with this, we have seen tremendous interest in our S&P Paris-Aligned & Climate Transition Indices, which model how an investor might invest with the objective to keep global warming below 1.5 degrees Celsius.

There are also thematic indices, such as those focused on clean energy, water, etc. We expect that this will continue to expand into other themes moving forward. Another area is what we call “best in class” ESG indices – indices that include companies with the best ESG performance –which are especially attractive for high-conviction ESG investors.

"Ultimately, we are heading in the direction where there is going to be an ESG variant for every traditional index"

Traditionally, a lot of investors have shied away from incorporating ESG in their strategies because they felt that doing so would impact performance.

ESG indices, such as the S&P 500 ESG Index, are designed to address this perceived trade-off and have risk and return profiles that are very much in line with their respective parent benchmarks. In some instances, these ESG versions of mainstream indices have performed better than their parent benchmarks.

These ESG versions of our core or mainstream indices have been successful because they capture the broader market and tend to have a low tracking error relative to the parent index. This provides an easy transition for investors who are looking to incorporate ESG factors in their strategies because, from an investor standpoint, it is not viewed as super high stakes or a major trade-off.

Fund Operator: How is transparency ensured for investors in these indices?

Reid: In terms of transparency, there are a few different ways that we provide it through our ESG indices. First and foremost, we make the full weights of our indices available to our clients by providing information on the companies included in the indices. We publish our ESG index methodologies on our website for full transparency.

Externally, another trend is not just the positive market reinforcement, but also regulations that exist in different markets, such as the Sustainable Finance Disclosure Regulation in Europe.

This particular regulation encourages the availability of more standardized ESG information to the public so that investors can make informed decisions. This ultimately serves investors well.

Fund Operator: How often are the indices reviewed and rebalanced?

Reid: They vary. Our two most high-profile indices, the S&P 500 ESG Index and the Dow Jones Sustainability Index are rebalanced and reconstituted annually.

The S&P 500 ESG Index is rebalanced in April, while the Dow Jones Sustainability Index is typically rebalanced each September (in 2020 the rebalance was postponed until November due to the COVID-19 pandemic).

"For many of our ESG indices, we also monitor and review for any controversies"

This annual process enables us to review our ESG indices’ sector weights and composition to ensure that they continue to meet their stated objectives.

For many of our ESG indices, we also monitor and review for any controversies that may arise from the companies that we are tracking. If a company is embroiled in major controversies, it is possible for it to be removed at any time other than during the annual rebalance and reconstitution.

This took place in 2019 with respect to Johnson & Johnson, as well as during a recent case involving a Brazil-based company.

Fund Operator: Are there fixed income ESG indices, and if not, is there a possibility of seeing them in the future?

Reid: Most of the growth has been in the equity indices, but we do see great potential when it comes to fixed income ESG indices.

We offer green bond indices. For example, there is an ETF based on one of our green bond indexes here in the US, as well as the S&P 500 Carbon Efficient Bond Index.

"We do see great potential when it comes to fixed income ESG indices."

We recognize that there is a lot more work to do in this space and we expect to launch more ESG indices in 2021 and beyond.

Fund Operator: Are there other securities that are proving useful for investors in the ESG space?

Reid: It is not just in funds where ESG is emerging, but we are also seeing ESG indices gaining traction in the derivatives space. There are now futures and options contracts based on the S&P 500 ESG Index, which gives investors different ways to incorporate ESG.

In particular, the S&P 500 ESG Index e-mini futures on the CME have really gained traction and are seeing strong volumes as of late, further supporting the growth of ESG.

Fund Operator: Are you seeing this as more of an overlay strategy to be able to get additional exposure or ancillary exposure to ESG?

Reid: There are a couple of different use cases, including fund product providers who are looking for exposure without creating a cash drag on the portfolio. Another use case that we see as we go into other geographies are in ESG-focused structured products.

This allows product providers to have all elements of their strategy focused on ESG, as opposed to just certain components.

 

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