This dissection of an ESG index is by The Scientist from Team Monevator. Check back every Monday for more new perspectives from the Team.
People like to throw the ‘ivory tower’ label at scientists like me. And it’s true, we can be guilty of making what we do inaccessible to everyone else.
But for inaccessibility of language made into a true art form, nobody beats the financial industry.
Environmental, Social and Governance investing (or ESG for short, because acronyms always help…) is not a new fad. Nor is the concept very complex.
Yet I had no end of difficulty digging into the background of ESG indexes.
Introducing the ESG index
The core idea of ESG investing is to grow your wealth whilst trying to do some good.
Back in 1990 a group called KLD Research & Analytics started the first Socially Responsible Investment index (or SRI, because one acronym is never enough).
MSCI took over KLD’s index at a later date. MSCI now offers some 1,500 ESG indexes. There’s an ESG index for everything from human rights and climate change to the fallout from the COVID-19 pandemic.
The purpose of investing is to build wealth. And as it happens, since 1990 that first US-focused MSCI KLD 400 Social Index has bested the US market.
But the motivation behind ESG/SRI investment is not to outperform.
ESG investors choose to invest in such a way as to encourage business practices that have a positive impact on the world.
An ESG index dissected
I decided to look under the hood of an ESG index to see how it worked. I chose one closer to home: the FTSE4Good Developed Index.
The FTSE4Good index series is “designed to measure the performance of companies demonstrating strong ESG practices.”
The index I’ve chosen is an ESG take on the FTSE Global Developed World index.
Companies are screened for inclusion in this ESG index. The screen employs a convoluted algorithm containing about three layers. I say ‘about’ three layers, because the algorithm gets pretty complex, pretty quickly.
First, the relevance of the three ESG ‘pillars’ are considered with respect to a given company. These are: Environmental, Social, and Governance.
Then, within each pillar there are further ‘themes’.
Environmental:
- Supply Chain: Environmental
- Biodiversity
- Climate Change
- Pollutions and Resources
- Water Security
Social:
- Supply Chain: Social
- Labour Standards
- Human Rights and Community
- Health and Safety
- Customer Responsibility
Governance:
- Anti-Corruption
- Corporate Governance
- Risk Management
- Tax Transparency
Finally, within each theme are ‘indicators’.
Over 300 indicators are considered, with each theme containing 10-35 quality and data-driven indicators. For any given company, on average 125 indicators combine to calculate its ESG score.
Source: FTSE Group
Points mean prizes
Based on the indicators, a company gets a score out of five. Zero is totally rubbish, from an ESG perspective. Five is industry-leading best practice. Each theme and pillar is scored.
Theme and pillar scores are then weighted based on their relevance to a given company. Enter another scoring system – this time out of three. Zero is irrelevant and three is high.1
The relevance weighting reflects how responsible a company ought to be with respect to a certain theme. It’s determined by industry.
For example, you wouldn’t expect an insurance company to undertake many activities directly related to water security.
Super, smashing, great
Confusingly, the calculation of a company’s ESG score works backwards from how it is presented in the FTSE4Good documentation. It runs from indicator to a final ESG score.
But there is yet another step. A company’s ESG score is also weighted relative to the performance of other companies within its ‘supersector’.
What’s a supersector? Well, there is a supersector ‘taxonomy’, according to FTSE Russell’s Industry Classification Benchmark:
- Technology
- Telecommunications
- Health Care
- Banks
- Financial Services
- Insurance
- Real Estate
- Automobiles and Parts
- Consumer Products and Services
- Media
- Retailers
- Travel and Leisure
- Food Beverage and Tobacco
- Personal Care, Drug and Grocery Stores
- Construction and Materials
- Industrial Goods and Services
- Basic Resources
- Chemicals
- Energy
- Utilities
Their index, their rules, but scoring a company’s ESG rating relative to a supersector seems counterintuitive to me.
Why? Well let’s say everyone in the Energy supersector burns coal. Just because you burn less coal than others in your supersector, for me that doesn’t diminish the fact you burn coal. Or use slave labour. Or manufacture cluster bombs.
Worse, some of the indicators used to calculate the ESG scores are “tailored for different industrial sectors”. So sector-relative scoring is already at the heart of the ESG calculation. It is potentially accounted for twice.
No score draw
After all this accounting alchemy, a company has a score out of five.
The company needs to score 3.3 or higher to get in a FTSE4Good index, in a Developed market. (2.9 or higher in an emerging market).
But wait, no, actually there is one more consideration!
Some kinds of companies are actively excluded. This includes those that manufacture or produce tobacco, chemical and biological weapons, cluster munitions, nuclear weapons, conventional military weapons, firearms, coal, or are investment trusts.
Personally, I find this the most concerning. It suggests the long, complicated ESG calculation we described above doesn’t already work to exclude companies that partake in these naughty list activities.
So what was the point of it all?
Indeed, what is the point of ESG?
Again, the point of ESG is not to outperform the market.
Just as well. As recently reported in the Financial Times [search result]:
“There is no ESG alpha,” said Felix Goltz, research director at Scientific Beta and co-author of the as yet unpublished paper, Honey, I Shrunk the ESG Alpha.
“The claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed,” with analytical errors “enabling the documenting of outperformance where in reality there is none”, he added.
Financial Times, 3 May 2021
Deciding to invest by considering ESG scoring should instead be a decision to allocate capital towards companies that do ‘good’.
For me, ESG indexes are not a perfect means to that end. Perhaps more convoluted than effective. But they’re better than nothing.
What’s the alternative? You could instead investigate every single company you invest in. But then you’re an active stock picker. That does not go well for most people.
Passively investing via index funds is the best way to go for nearly everyone.
And if you want to include ESG considerations in your passive investment strategy, then choosing funds that follow ESG indexes is a simple way to do this.
Two cheers for ESG index funds
Choosing to invest in ESG funds is a bit like shopping for Fair Trade coffee, carbon offsetting your gas bill, or buying an electric car. You’re making a choice with your spending power to try to make some small difference.
Investing in the status quo means you will only ever get the status quo. We have to start somewhere.
It may be hard to understand the rationale behind any given ESG index, but alternative ways to invest in an ESG-friendly way don’t work most of us.
By buying ESG funds, you at least indicate to the market that there is a demand for ESG products. Hopefully they’ll get better and clearer in time.
In time you will be able to see all The Scientist’s articles in their dedicated archive.
- FTSE calls relevance ‘exposure’. [↩]
Comments on this entry are closed.
I looked into investing in ESG funds a while back but was put off by the fact Nestle was one of the top holdings. This is the same Nestle currently draining natural water sources in order to bottle it and sell it, the same Nestle who also argued that the right to access water should be changed from a right to a “need.”
The same Nestle that has been linked to child trafficking and labour usage, misleading labelling practices, contamination scanadals, pollution scandals and on and on…
If they are considered worth of meeting the ESG criteria then I question the point of it.
If we snub sin stock, will it just get snapped up by unaccountable private equity?
You could just have an activist tracker – buy everything, vote ethically, not worry about filtering, not miss out on returns.
Probably quite hard to totally seperate something like a bank from everything it’s exposed to and ethics is subjective – some things like defense or petrol is unpleasant but imagine if we didn’t have it.
You could even say that paying tax = paying for defense
“Investing in the status quo means you will only ever get the status quo.” Great article but am afraid I disagree with the conclusions in this one.
If you believe in an efficient market that takes into account the values of the society it reflects, then there is no need to reward “ethical” companies on the supply side as demand from willing customers will drive change. If you believe that the markets need a push away from bad behaviour it’s still more effective / efficient to campaign for regulatory and political change (eg net zero emissions) than via passive investment trend following. I believe that indexing should be as low cost as possible and ESG scoring in its current form adds nothing except a feel good factor.
Great article, Scientist!
I have struggled to find decent ESG index funds, because it’s difficult to know exactly what’s in them. Also, I’m not sure how much oversight there can really be of the “G” with passive investment. So I have personally invested some of my funds in low-cost actively managed ESG funds over the last 5 or so years. At least then I know that the fund managers are in active conversation directly with the companies they invest in. Thus attempting to ensure they are governing their businesses well, including the “E” and “S” themes. I suppose it helps that, as a Paraplanner, I get invited to talks by the fund managers about their funds. How and why they select the underlying companies, be it positive or negative screening or a bit of both. And their long-standing history of good performance, because in the long run a well-governed company will likely stay afloat and make more money for its investors.
I also worry though about the popularity of ESG as a fad, and the many investment houses spinning up funds simply to get in on the action in more recent years. It’s concerning that investors could struggle to identify true ESG or SRI from the “greenwashed” funds that aren’t really ethical at all. Mainly because the assessment and rating method is so complex, as explained in your article. What are your thoughts on greenwashing?
If sin stock becomes undervalued, would we just end up with value investors / hedge funds buying them on margin, totally cancelling out the ESG effect?
Oooh look at this cheap dividend payer, there’s no financial reason for it to be so cheap, let’s buy more of it.
@Matthew writes:
There’s been some talk recently that this is how index funds could start to distinguish themselves from each other as ever more of the market goes towards passive tracking.
Some trackers could vote green, some could vote for social justice or for nationalist causes (e.g. domestic politics versus globalization) or for controlling CEO pay.
On the one hand this could be a direction of differentiation that’s more interesting than being two basis points cheaper. But on the other hand, a bit of a subjective minefield and ESG is already a minefield!
It could be a good way for small funds to attract assets though. As @Matthew says, an ‘activist tracker’.
I looked into this a while ago, particularly as regards emerging market funds, and ran into real problems.
The impression I got was that a company might score brownie points, say, for having low carbon emissions. It might also be contracted to run a slave labour camp for members of an ethnic minority…so it loses a “social” point. But it still get the OK because of the great environmental record… My impression was that E got far more attention than S and G.
The whole thing is far too broad brush to be meaningful. It needs human oversight, not just algorithms, to pick out the nasties. Otherwise, the modern-day incarnations of IG Farben get included.
Similarly, suppose a company is destroying large areas of rainforest and evicting indigenous communities without so much as a by-your-leave – but has plenty of women on its management board. It scores well on “diversity” – so what?
When I looked at the emerging market ESG indexes, the top constituents seemed to almost exactly mirror the bog standard index.
For emerging markets, I’d be interested in a more selective approach that focused on free speech, rule of law, democracy – so that at least the elements are in place to address egregious wrongs. Transparency and a lack of corruption presumably mean safer investments, too.
An interesting article – more on this would be welcome, not because ESG is great, but because it’s difficult.
L&G Future World ESG Developed Index is the closest to the world tracker I could find on H&L.
Agree with the article. Incomprehensible. There is a paucity of decent offers at good prices. I would like to invest “better” provided I am not ripped off to do so. Otherwise KISS. Do charitable works and lobbying elsewhere.
There was ill considered media coverage of this this month. We all have different priorities for the meaning of “better” – what you want “none of” – I might tolerate “some of” in pursuit of something else which I consider more egregious. And funds can’t be “pick and mix” to every investors unique take on the issues or fad du jour.
This peculiar index tracks global equities passive pretty well with the few knockouts as discussed in the article. So no worries really once you know what the major holdings are. I have used a FTSE4Good tracker fund for a long time as it was offered. At ~0.06% drag (scheme) or even the 0.3% retail version which nobody buys it’s moderately cheap and you can’t expect much ongoing scrutiny of deals the invested companies are doing at those prices.
So is it ethical (not very). Can it be a cheap equities proxy with a handful of sensible knockouts – why yes. Another minor deficiency of the specific index and fund implementation is the relatively short tail of equities – ~1500 if I recall rather than the 6000 or so of a full “long list” tracker. However reduction in concentration risk vs numbers is already well advanced at 150 never mind 1500 so this is not a major problem. To diversify away from US growth large cap tech demands a different approach anyway
A real problem for ESG is one of definition and any meaningful agreement thereon. Take oil companies transitioning to green energy – Are they “big oil” and *evil* never to be held in ethical funds but to be destroyed utterly – or at a point where their divestments, investments in different energy sources (and application of financial capital, logistics and human capital are aiding rather than blocking fossil fuel transition – do those companies then become “ethical”. People would disagree fairly passionately and fundamentally about this with arguments good and bad on both the purist and pragmatic side of the ledger.
Perhaps people could bid up the cost of carbon credits:
https://www.google.com/amp/s/www.nasdaq.com/articles/supporting-sustainability-through-a-global-carbon-etf-strategy-2021-04-22%3famp
Seems quite uncorellated too!
Do think as well the activist tracker idea might help negate fears about the passives having too much influence – people start to ask what are they doing with all that voting power? It might look less hard line than a total boycot but who else would be left to own and run these companies? Resources that went into filtering can go into governance.
I certainly agree with many of the comments here that there should be something better than ESG style trackers. But treading that line between being active and passive is a big challenge if you want to have some consideration in how you invest. I’m suggesting here that ESG algorithms are a useful start but certainly not the solution.
On the one hand, selling green products that are in essence greenwashing is a real problem. Many people are looking for green credentials in their products but these tend to be opaque, requiring a lot of research to really dig in and find out if they are legitimate. And at that point you might as well be more active – although I guess if you’re investigating cost/number of companies included in the tracker etc. is it a lot more work to investigate the ESG credentials?
On the other hand, I’m not sure I would trust market efficiency to get us there! It is fair to say that policy changes and significant societal shifts should ultimately be reflected in standard investment trackers. But something still has to cause that shift, and that will only happen if we as a society demand that this shift occurs which generally occurs via voting both politically and with our wallets, not to mention community initiatives.
For what it’s worth, I incorporate a mix of ESG and standard trackers/funds in my portfolio. And I primarily content myself with having a career as an Environmental Scientist, where my day to day involves trying to make a small difference on the E part of the spectrum.
Hi Scientist, good article. I tried a FTSE4good tracker, but ended up switching back to basic all world tracker as c30bps vs 9bps annual fees with my pension provider and I felt the ESG scoring was pretty opaque, or as you allude to companies could game the system. I also reflected that BP, Shell etc are some of the biggest green energy investors at present.
Ronald Cohen explains the need for change in accounting standards and the shortcomings of current measures of profit for listed companies in his 2020 book Impact: reshaping capitalism to drive real change.
He also believes corporates with highest impact adjusted profits will outperform over the long term, not least because bad corporate citizens will eventually be taxed more, face greater regulation or just be sued with respect to their negative societal impact.
To be clear I’ve still not got around to reading this book (it’s been a busy 12 months!) but it is summarised here
https://blogs.cfainstitute.org/investor/2021/02/18/impact-weighted-accounting-the-missing-ingredient/
Or there is a free investors chronicle podcast featuring Ronald Cohen from 27 July 2020 that you can still get on Spotify which explains impact and how it might be measured in audited accounts and why investors should care. (About 25 mins long)
It’s on my to do list to check out this book and also to potentially switch some of my pension back to ESG trackers later this year.
It is always interesting to read about new forms of “active “ investing -the latest of which is ESG investments
I personally have never mixed my savings with politics and changing the world
This may be a mistake but being able to save enough always took precedence
I tended to regard these recurring “new” ideas as a confirmation that I should stick to my global trackers as each fad had its day then faded away
I also assumed that if the new idea was a “goer” that it would soon be included in the index and that I would benefit accordingly
Too cynical perhaps probably more likely an older and hopefully wiser investor!
xxd09