Traditional approaches to creating ESG indices, result in a “fairly large set of unintended bets on other risk factors,” a new study has suggested.
Analysts at research house Axioma said the traditional index construction approach is not effective, as it makes it difficult for investors to assess whether any outperformance is being generated from the ESG tilt or from other tilts also present in the index.
Traditional index construction approaches typically sort a universe of stocks using companies’ ESG scores, eliminating those with the worst rankings, and cap-weighting the remainder to avoid a small cap bias.
In its report entitled ESG’s Evolving Performance, Anthony Renshaw, director of Index Solutions at Axioma, said ESG indices often have considerable tilts to other factors, such as value and growth, which are just as large as the active ESG tilt, meaning it is difficult to attribute any outperformance to an ESG screen.
“A significant portion, if not the majority, of existing ESG indices are constructed using a simple sorting approach,” Renshaw wrote.
“While this approach is simple to implement and explain, it suffers from the defect that the active tilt on ESG is typically small. In many cases, the active tilts on other risk model factors such as value and growth are just as large.”
Renshaw says while it is easy to “backtest” portfolios to spot outperformance, investors will be “hard pressed to attribute any outperformance to ESG” as opposed to other factors or even luck.
In an interview with ESG Clarity, Patrick Connolly, spokesman for UK financial advisory group Chase de Vere, said his company did not currently use any funds that tracked an ESG benchmark.
“I would agree entirely with the sentiment from this report,” he said. “If you have an ESG index or an ESG tracker fund, how do you attribute the performance to the ESG factor? It is likely to have a very small influence.
“It is difficult to gauge an ethical benchmark and it is even more difficult with an ESG benchmark, because it is so subjective. It is incredibly difficult to construct an ESG index with criteria that people that will generally adhere to.”
Connolly said he believes that a better approach is for individuals to tailor their investments to their specific beliefs, with the guidance of their financial adviser during the portfolio construction process.