Incorporating ESG Into Your Portfolio: What are the options for index investors?
Incorporating ESG considerations into portfolios is clearly a growing priority for many investors today. Whether driven by regulation, investment beliefs or values — investors are increasingly asking how their indexed or passive investments can adapt to new realities. Index managers have broadened their toolkits and are able to offer portfolios that no longer just capture the wider market but that have specific objectives, such as efficiently incorporating ESG criteria. So, how can index managers help investors futureproof their portfolios?
ESG and Performance
First, a word about performance. In a recent paper we looked at a number of studies that measured the performance in shares globally over the recent COVID19 crisis period and beyond, and found that there was significant outperformance related to high-scoring ESG stocks over the periods studied.
An HSBC study measured the share performance of over 600 public companies globally and found that climate-focused stocks outperformed others by 7.6% from December 2019 going into the crisis period and generally high ESG-scoring shares beat the others by about 7%.
In another study, Morningstar found that sustainable and ESG equity indices outperformed conventional indices in the Global, Europe and US Large-Cap categories in the month to March 2020.
In other words these studies suggest that the right ESG-aligned portfolios can provide good downside protection and a useful uptick in performance. Now, let’s go on to consider the four key ways that ESG criteria can be successfully incorporated into index portolios.
Screening Out to Improve ESG Profile
Investors make wide use of exclusions to keep their ESG incorporation simple and manageable. In fact, out of the $30+ trillion in global ESG-labelled assets, the majority were in exclusionary screens, either norms- or investment-led. In Europe, exclusion still represents more than 50% of total ESG assets, even if approaches such as integration and best in class have been growing at a faster pace.
The Returns Question
For many investor the question arises: am I harming my return potential by excluding companies from my investable universe? A 2017 paper from MSCI seems to suggest that some level of exclusions are not harmful to performance. In fact, it may even be moderately positive if those exclusions are concentrated on the worst types of corporate wrongdoing. Also, larger companies do seem to be impacted more by negative events. Investors that use market-cap-weighted indices, where allocations to companies are determined by their size, should be particularly mindful of that.
Getting the Exclusions Right
An important consideration for any investor is how the exclusion list should be defined. While screening may sound relatively simple, the process involves a significant amount of judgment on the part of the asset manager and/or their investors, and potentially the data provider with whom they partner to conduct the screening.
We believe that to be optimal, a screening process should have the following characteristics
- Be systematic and transparent
- Be aware of the potential impact on an investors’ risk and return objectives
- Be consistent but not inflexible; and finally
- Leverage best-in-class data. This may necessitate using multiple providers
We see exclusions as a straightforward way for investors to remove securities that could potentially be damaging to performance because of reputational risk (worst offenders) and/or changes in regulation/consumer preferences.
Read the full report here.