Incorporating ESG into US equity benchmarks

Investors that want to incorporate environmental, social and governance (ESG) considerations into a broad US market passive portfolio have traditionally had to accept a certain – often high – level of deviation from the risk and return characteristics of the underlying benchmark.

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Alongside the mainstreaming of ESG into passive investing, the surge of interest in sustainable investing is translating to growth in assets in the US. Today, up to $550 billion of assets under management (AUM) are in ESG or socially responsible investment (SRI) funds – an 88% increase since 20181.

FTSE Russell's senior product manager of sustainable investment Carolyn Eagle and Tony Campos, head of sustainable investment, Americas at FTSE Russell, an LSEG business tell Environmental Finance how the above trends have led to new index developments.

Environmental Finance: What interest are you seeing in ESG investing in the US?

Tony CamposTony Campos: More institutional investors are considering ESG than ever before. Our 2021 survey found that more than eight in 10 (84%) asset owners globally are evaluating and implementing sustainable investment (SI) considerations in their investment strategies, up from a little over half (53%) in 20182.

In North America, a region that has historically lagged other parts of the world on ESG investing, the survey showed it is quickly catching up with EMEA. In North America, 68% of asset owners surveyed said they were either implementing or considering ESG, increasing from 39% in the last three years.

We learned that North American asset owners are motivated by investment returns, as their top two reasons for implementing or considering an SI strategy were: mitigating long-term investment risk (60%) and achieving better risk-adjusted performance (51%).

EF: Are fund flows matching the levels of interest?

Carolyn EagleCarolyn Eagle: In short, yes. The growth in interest is translating to growth in assets in the US. With the Refinitiv Lipper team we looked at what kinds of ESG strategies in the US market are attracting increasing levels of investment.

Firstly, it's important to understand definitions. Lipper's ESG/SRI universe of funds consists of funds that meet specific criteria to obtain one of the following flags: Social, Environment, Green, Ethical, and/or Religious.

Fund flow data, according to Lipper, indicates that most of the sustainable fund flows are into passive equity strategies. In fact, since the start of 2020, passive ESG/SRI funds saw ~70% of total inflows, while only accounting for ~25% of total AUM in ESG/SRI funds.

While active ESG equity estimated net flows are hovering around zero (meaning about as much AUM is flowing out as flowing in), ESG passive equity AUM estimate net flows are positive, and even ticking up in recent months.

Lastly, Lipper data indicates that while overall passive estimated net flows remain in positive territory, passive ESG AUM is steadily increasing month over month.

ESG/SRI estimated net flows ($Mil) into US equity since January 20203.

EF: What is an ESG equivalent of a flagship benchmark?

TC: With the interest for a broad US market portfolio with different levels of ESG in mind, we designed the Russell US ESG Indexes. The suite of six indexes is a broad-based, alternatively-weighted, US equity index family designed to measure the performance of mega-cap to micro-cap securities that meet improved index-level ESG profile, while maintaining similar risk/return characteristics to the underlying universe.

There are two sub-index families available, with different levels of exposure to ESG:

  • Russell ESG Screened Target Exposure indexes. This sub-family of indexes applies a negative screening approach, by excluding companies based on certain business operations or product involvement. Companies are also excluded that potentially breach the United Nations Global Compact principles.
  • Russell ESG Enhanced Target Exposure indexes -This sub-family of indexes applies the same negative screening approach as the 'ESG Screened' indexes. In addition they apply Refinitiv ESG Scores as a tilt to provide an ESG lens on the US equity universe.

By applying the Refinitiv ESG scores into FTSE Russell's Target Exposure index methodology we can produce an index with a 10% ESG score improvement that is still investable and performs similarly to the benchmark.

EF: How are company ESG practices and commitments assessed for those indexes?

CE: The Refinitiv ESG Score framework is designed to transparently and objectively measure a company's ESG performance, commitment and effectiveness across 10 main themes based on publicly reported data.

The scores are a data-driven assessment of companies' relative ESG performance and capacity, integrating and accounting for industry materiality and company size biases. Specifically, the scores measure the company's ESG performance based on verifiable reported data in the public domain.

The scoring methodology captures over 450 company-level ESG measures, of which a subset of 186 of the most comparable and material, per industry, power the overall company assessment and scoring process.

EF: What is the benefit of using FTSE Russell's Target Exposure approach for an ESG index?

TC: FTSE Russell's target exposure approach provides a transparent mechanism for exercising complete and precise control over both investment and ESG objectives.

For these indexes the approach neutralises active industry exposure while also controlling tracking error and beta. This, combined with industry active weight changes, should offer investors the confidence that the ESG indexes can serve as a suitable alternative to the underlying benchmark.

Another benefit of employing the target exposure methodology is that the tilting outcomes are transparent and therefore can support ESG-related stewardship activities and stakeholder communication.

Secondly, outcomes can be enhanced as necessary. As new ESG data become available or scores in the index universe improve, the investor can 'raise the bar' for ESG improvement as needed.

EF: Is there any evidence that these ESG indexes outperform?

CE: In recent years, it has become more accepted across the industry that there is correlation between ESG performance and listed equity risk-adjusted returns, due in part to the correlations between better management of ESG issues and risks, and corporate financial performance, cost of capital, market valuations and volatility4.

While it is important not to confuse correlation for causation, we do find in practice some evidence of risk-adjusted outperformance of ESG indexes against their parent benchmarks. Over the period from December 2016 through August 2021, the Russell 1000 ESG Enhanced Target Exposure Index outperformed the underlying benchmark's annualized gain of 18.68% by 97 basis points, with comparable volatility. The tracking error over this period remained under 1%, at 0.92%.

Over the same time period, the Russell 1000 ESG Screened Target Exposure Index had an annualized return of 19.63%, compared with the Russell 1000 Index return of 18.68%.

Further, an alternatively weighted index methodology, in this case Target Exposure, produces indexes that behave very similarly to their underlying benchmark and therefore can be seen as suitable replacements for the traditional benchmark, further driving assets into the strategies. It can serve as a gateway or steppingstone for a new ESG investor.

Russell 1000 ESG Enhanced Target Exposure Index vs Russell 10005

EF: How can these indexes be used by market participants?

TC: The indexes are suitable substitutes for the traditional benchmarks and can be used by market participants in a number of ways. Firstly, to benchmark the performance of US equity funds. Secondly, in the creation of ETFs, structured products and index-based derivatives. Or, lastly, as an ESG alternative for core US market cap-weighted, passive mandates and model portfolios.


Notes:

Refinitiv Lipper, July 2021. Includes both active and previously liquidated funds (ETFs and mutual funds)
2 FTSE Russell, Sustainable Investment: 2021 global survey findings from asset owners
3 Refinitiv Lipper, July 2021. Past performance is no guarantee of future results
4 PRI: ESG factors and equity returns – a review of recent industry research, 2021
5 FTSE Russell, based on monthly data from December 31, 2016 to August 31, 2021.