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What goes into an ESG index?

Posted By Team Monevator On In Investing | Comments Disabled

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 [1] 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 [2].

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:

Social:

Governance:

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.

[3]

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 [4]

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 [5]:

  1. Technology
  2. Telecommunications
  3. Health Care
  4. Banks
  5. Financial Services
  6. Insurance
  7. Real Estate
  8. Automobiles and Parts
  9. Consumer Products and Services
  10. Media
  11. Retailers
  12. Travel and Leisure
  13. Food Beverage and Tobacco
  14. Personal Care, Drug and Grocery Stores
  15. Construction and Materials
  16. Industrial Goods and Services
  17. Basic Resources
  18. Chemicals
  19. Energy
  20. 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 [6] [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 [7] for most people.

Passively investing via index funds [8] 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 [9].

  1. FTSE calls relevance ‘exposure’. [↩ [14]]