Integrating ESG into Index Investing

Two of the main arguments made by ESG advocates are that  “values can impact value” and “ESG factors correlate with better corporate financial performance.” I’m sympathetic to both arguments, although they both seem better suited to an active management context (due to higher levels of portfolio concentration and greater emphasis on fundamental analysis). Yet, as investors increasingly shift assets from active to passive, it is worthwhile to examine how ESG considerations impact index characteristics.

The below is not meant to be a comprehensive study, but simply illustrative of what investors can expect from a plain-vanilla ESG-oriented portfolio. The red area (below) represents the distribution of high-level ESG scores (from a well-known ESG analytics firm) for the portfolio of traditional large-cap index fund. The green area represents the same distribution, but applied to an ESG-themed large-cap index fund that optimizes for ESG score.

source: Bloomberg

This particular fund is fairly representative of many ESG-themed funds and receives good high level ESG scores from multiple ratings firms. While the distribution is shifted meaningfully to the right, it is still a relatively modest shift. This is not meant perjoratively as radical shifts often result in unacceptable risks and/or tradeoffs.

Below is the same data in a different format, but with the same conclusions: there is a slight shift of weighting from companies in deciles 2-5 towards companies in deciles 8-10.

source: Bloomberg

When investors are optimizing for high level ESG scores, it is important for passive ESG investors to understand the above dynamics and to maintain reasonable expectations in terms of objectives, portfolio characteristics, and performance. This is especially true when considering the uncertainty surrounding high level ESG ratings (see here and here), the increasing amounts of “greenwashing,” and questionable claims from some sponsors and managers.