The Index Approach to Integrating ESG into the Investment Process

Oscar Wilde – “…the unspeakable in pursuit of the uneatable.”

Responsible Investing (RI), was once a secondary or tertiary consideration but it has now become the central theme in investment management. There are over 3,000 asset manager signatories to the United Nations Principles for Responsible Investment. Reports from Deloitte and from PWC predict that North America asset managers will rapidly conform to a responsible investing discipline. The North American asset management industry, specifically the US, has the influence and the power to effect significant improvements in climate change, Diversity, Equality & Inclusion and other important aspects which define our world.

Responsible investing is not a defined concept but rather a wide spectrum with many different, possibly confusing approaches.  Screening out undesirable sectors or companies negates any progress which could be made through active engagement or proxy voting. Positive inclusion can result in a narrow opportunity set, producing significant Tracking Error, making it difficult to meet investment objectives.

The simple unifying principle in all approaches is the desire to allocate capital in a clean and responsible manner, but anyone with fiduciary obligations must consider the ramifications very carefully. McCarthy Tetrault wrote an extensive article describing the duties fiduciaries must meet when implementing RI within their investment mandates. The authors concluded ESG approaches may be the most suitable because they may minimize constraints which pose impediments to meeting required rates of return.

How can investors perform due diligence to assess where managers get their data, the degree to which the data is integrated into managers’ investment processes and the extent to which the information will influence security selection? This is a monumental task which could be simplified using more transparent and consistent data for a more thorough due diligence.

The major index providers have strong RI/ESG credentials, combining their RI/ESG expertise with their extensive benchmark index methodologies. In contrast to Active managers, Index providers offer consistent and transparent rules-based strategies which can be applied uniformly across regions and asset classes, creating a cohesive policy for investors to direct their Capital responsibly.

Moreover, index based ESG exposures provide a solid foundation for fiduciaries to evaluate how any exposure refinements may influence investment performance. For asset owners doing asset-liability studies, this is a major consideration because an ESG index data set, taken from its broad beta parent index, is very likely to be highly representative of the economic opportunity set in the economy.

Several large pension plans, most notably Ilmarinen in Finland, have allocated significant assets to Index ESG strategies, motivated by their transparent rules, their diversification and their ease of execution. In other instances, Institutions have used ESG policy benchmarks so they can align their capital allocation with their objectives.

In a competitive industry, it is not surprising that ESG presents yet another opportunity to criticize the attractive simplicity Indexing brings to investment management. Putting aside the Active versus Index debate, are the Indexing ESG criticisms valid?  It is important to evaluate them to gauge their relevance:

1.  Diverse methodologies result in inconsistent ESG scores

Regardless of whether RI/ESG strategies are Active or Index, there are many different approached. Before leveling a criticism, we should acknowledge that variety is inevitable in a discipline which lacks universal definition.

Do different scores imply weakness, or do they illuminate areas where deeper evaluation is warranted?  Interestingly, there is only 60% correlation across index providers on company ESG scores, thus the criticism (ESMA Report on Trends, Risk & Vulnerabilities, J Mazzacurati, 2021). In contrast, there is 99% correlation across credit agencies rating bonds, and this created a furor during the credit crisis.

Rating RI/ESG includes far more data points than rating bonds, so it stands to reason that there would be dispersion across different rating organizations, be they data providers or Indexing firms.  Independent assessment should not be valuable in one realm but disparaged in another.

It is important to acknowledge that investors who appoint active managers across different asset classes and regions will end up with a patchwork quilt portfolio which has inconsistent methodologies. In contrast, an index approach provides consistency across the portfolio, a more robust and uniform RI/ESG policy and investment model for asset-liability measurements.

2. Aggregate ESG scores mask the relevance of company scores

While some investors may choose to buy individual companies to tailor their own exposure, most buy portfolios in ETFs or pools. As such, they examine portfolio characteristics like beta, Sharpe ratio, tracking error and so on.

Furthermore, studies continue to confirm Brinson, Hood & Beebouwer’s findings (Determinants of Portfolio Performance, 1986) that minimize the importance of security selection as a determinant in meeting long-term objectives. From this perspective, an index with minimal tracking error should have very similar beta and Sharpe ratio characteristics to its parent index, while achieving significantly improved ESG scores, regardless of any anomalies which may occur at the company level.

If progress is achieved in increments, ESG Indices provide consistent and transparent measurement to monitor whether, in aggregate, capital is being responsibly allocated.

3. Passive investors can choose to ignore undesirable constituents

Critics have suggested passive investors, like ETF providers, should choose not to include undesirable companies, overriding index construction, in an effort to meet RI/ESG expectations.

Such comments misunderstand that passive investors who provide index exposures cannot unilaterally exclude companies, yet charge a management fee to replicate said index. To do so would create significant tracking error, raising fiduciary questions, and could arguably be called a misrepresentation.

RI/ESG index providers measure, rank and weight companies when they construct investable benchmark exposures. This cleanses capital but also maintains a strong investment thesis.

Conclusion

Responsible Investing or ESG is one of the most difficult things to integrate into the investment process for investors large and small. Highly technical knowledge is required to sift through myriads of data across the Environmental, Social & Governance considerations, requiring on-going monitoring, measuring and rating. Exclusion is easy, but it is a dull tool which prevents activist investors from exerting a positive influence for change.

Investors wishing to showcase their own governance, demonstrating they have met fundamental investment principles while responsibly allocating their capital should consider using an ESG Index. In the absence of an empirical method, the essence of what RI/ESG strives to achieve can be most accurately evaluated through explicit and consistent index methodologies. An index can provide a lower carbon footprint, higher social and governance scores and a sound risk management screen to enhance invested capital.

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RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Author

Mark Webster

Director, ETF Sales, Institutional Sales & Service

BMO Global Asset Management

Mark is the BMO ETF team's representative for Western Canada. With over 30 years of experience in the financial services industry, Mark has covered many diverse forms of financial risk. He began his career as a professional indemnity broker, becoming a vice president at Minet International Professional Indemnity Ltd. (now part of AON), conducting risk analysis for the Big 8 global accounting firms, as well as some of the top U.S. law firms. He is responsible for overseeing the proliferation of ETFs throughout Canada's vast western region and providing support to portfolio managers from the Pacific (Duncan B.C.), to the Lakehead (Thunder Bay, Ontario). He has worked as a retail investment advisor with RBC DS; in the mutual fund industry with First Trust Portfolios; and has held several other positions in the pension industry. He brings with him a Master’s degree in Russian History from McGill University and several CSI accreditations.