ESG and Index investing are on the rise. What do investors need to know about distinguishing between opportunity and risk in ESG Index investment solutions? Read our complete analysis to find out.
At a glance:
- Assets managed in sustainable funds are increasing, and indexes that consider environmental, social, and governance (ESG) factors represent an efficient way to allocate capital.
- Given recent noise in the media about what ESG is and isn’t, investors need to be aware of the clear distinction between ESG investment opportunity and ESG risk.
- ESG indexes approach the integration of environmental, social, and governance considerations from a risk management perspective with important investment implications such as lower volatility and improved Sharpe ratios.
In 2021, the number of ESG indexes—benchmarks with environmental, social and governance considerations—grew by 43%, building on a 40% jump in the year prior. By comparison, the number of indexes tracking other market criteria increased by only 5%.1 This exceptional growth is undoubtedly a response to the fast-growing popularity of sustainable funds. Case in point: in Canada, assets in sustainable funds doubled last year, from $17.4 billion to $34.5 billion.
Although this meteoric rise can be partially attributed to market appreciation, fund flows are the primary driver. We saw the strongest inflows on record in 2021, with approximately $15 billion in net new money directed towards Canadian sustainable funds. Passive strategies benchmarked to an ESG index led the way, growing 160% year-over-year.2 Why? Because ESG indexes offer investors not only an efficient way to allocate capital, but also an easy way to align their investments with their values.
A recent OECD study shows that 77% of ESG investing was motivated by social considerations or personal principles. Ironically, this impulse runs contrary to the original purpose of integrating ESG considerations into the investment process, which was to move away from subjective values and towards metrics that can be quantified and better linked to financial outcomes.
ESG Investing – And How Indexes Fit In
ESG investing can be traced back to Socially Responsible Investing (SRI) – a movement popularized in the post-war era of the 1950s when investors moved away from companies connected to weapons manufacturing. These restrictions soon expanded to include any company that was involved in controversial business activities, such as manufacturers of tobacco products, thermal coal miners, and energy producers. The returns on SRI investments tended to underperform their benchmarks, as the hardline exclusions left investors exposed to certain types of investment risk, including increased tracking error relative to their index and volatility as a result of highly concentrated portfolios.
To avoid these shortcomings, investors shifted their focus towards a more pragmatic approach: ESG integration. The idea is that societal values give rise to a certain set of environmental, social, and governance considerations that have financial implications. By this definition, ESG is sector- and industry-agnostic – regardless of business activity, all companies have their own set of ESG considerations to manage. Instead of excluding companies by business activity, companies are investable provided they can realize their opportunities while mitigating their ESG risks.
That said, ESG investment products are riddled with ambiguity, as recent pieces by Barron’s4 and the Globe and Mail5 highlight. At the foundation of most of these products are ESG ratings, which are meant to provide a blanket summary of company ESG performance. Ratings vary across different service providers; a company that is rated highly by one may be scored poorly by another. Ultimately, the ratings raise some important questions: Do they represent ESG opportunity or risk? And how can investors assess companies for ESG opportunities in light of ESG risks?
Indexes can reduce some of this ambiguity. At a high level, indexes facilitate capital allocation across a diverse set of companies in a way that mitigates risk (more on that below). Naturally, then, an ESG index would prioritize ESG risk management over seeking out ESG investment opportunity. While methodologies vary, all index providers assess the ESG risks facing a company. The better a company manages its ESG risks, the higher its rating, and the greater the likelihood it will be included in an ESG index. It is important to note that these risk assessments represent the proprietary views of the index provider. With the multitude of considerations that fall under E, S, and G, no one provider will be able to capture all ESG risks nor will there be consensus as to what constitutes ESG risk across all providers.
ESG Indexes and Risk Management
As investors well know, the best way to minimize risk in a portfolio is by diversifying across multiple holdings. Therein lies the attractiveness of index investing. By buying an index, investors quickly deploy their capital across a wide range of companies—meaning that risks are automatically minimized. In that regard, an ESG index reduces exposure to ESG risks. What it doesn’t do is reward companies for capturing ESG opportunities. MSCI, the leading ESG ratings and index provider, notes that its ratings assess “resilience to financially material environmental, societal and governance risks” rather than measuring “corporate goodness.”6
If investors only approach ESG integration from an opportunity perspective (i.e., by the goodness a company produces), then the composition of ESG indexes can sometimes feel at odds with investor values. For example, the recent removal of Tesla from the S&P 500 ESG index despite the company’s reputation as a leader in the clean energy transition. Rather than rewarding Tesla for its ability to capitalize on climate change technology, racial segregation at its production facilities and product safety issues escalated the company’s risk levels to the point where it was removed from S&P’s ESG index.7 Other times, however, this risk management approach does reflect investor sentiment, such as when the Russia-Ukraine conflict made owning Russian securities extremely risky and they were removed from the MSCI indexes.
While there needs to be better distinction between ESG investment opportunities and ESG as a form of risk management, the benefits of the latter approach are clear. There is an increasing body of research that shows that the effective integration of ESG factors result in lower portfolio volatility and improved risk-adjusted returns. For example, one study found an “ESG-efficient frontier” where portfolios with higher ESG scores had improved Sharpe ratios.8 Even some skeptical researchers concluded that there is no cost to ESG investing – meaning investors are not sacrificing any returns when integrating ESG considerations into their portfolios.9
How BMO GAM Can Help
Today’s sustainability challenges pose significant risks, with labour disputes, cybersecurity breaches, and climate change all potentially disrupting companies’ ability to operate. At BMO Global Asset Management, we offer a range of ETFs benchmarked to ESG indexes to help investors more easily navigate these challenges—an approach further enhanced through our strong stewardship program. By actively engaging with our investee companies and exercising our right to vote, we ensure that ESG considerations are reflected throughout our investment decisions. Learn more about how our Stewardship work supports positive change at companies across our portfolio.
Direct: For more information on how our ESG ETF solutions can fit your investment objectives, visit our ETF Centre or contact a financial advisor today.
Advisor/Institutional: For more information on how our ESG ETF solutions can fit your investment objectives, please visit the BMO Canadian ETF Dashboard or reach out to your regional ETF specialist.
BMO ESG ETF Solutions:
- BMO MSCI Canada ESG Leaders Index ETF (Ticker: ESGA)
- BMO MSCI USA ESG Leaders Index ETF (Ticker: ESGY)
- BMO MSCI USA ESG Leaders Index ETF (Hedged Units) (Ticker: ESGY.F)
- BMO MSCI EAFE ESG Leaders Index ETF (Ticker: ESGE)
- BMO MSCI Global ESG Leaders Index ETF (Ticker: ESGG)
- BMO MSCI China ESG Leaders Index ETF (Ticker: ZCH)
- BMO MSCI India ESG Leaders Index ETF (Ticker: ZID)
- BMO ESG Corporate Bond Index ETF (Ticker: ESGB)
- BMO ESG US Corporate Bond Hedged to CAD Index ETF (Ticker: ESGF)
- BMO ESG High Yield US Corporate Bond Index ETF (Ticker: ESGH)
- BMO ESG High Yield US Corporate Bond Index ETF (Hedged Units) (Ticker: ESGH.F)
- https://www.indexindustry.org/insights/5th-annual-benchmark-survey-record-growth-in-number-of-esg-indices-alongside-broadening-of-fixed-income-indices/
- MorningStar Direct
https://www.oecd.org/finance/ESG-Investing-Practices-Progress-Challenges.pdf
https://www.barrons.com/articles/esg-investing-big-test-reckoning-51650041442
https://www.msci.com/our-solutions/esg-investing/esg-ratings/what-esg-ratings-are-and-are-not
https://www.sciencedirect.com/science/article/pii/S0304405X20302853
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