Do ESG indices have a place in active portfolios?

How useful are ESG indices? Are there limitations to their use? Are fund selectors and asset allocators using them correctly? We ask the CIO of one of the UK's leading investment consultants...

Last week, a research group flagged a series of concerns with the use of indices to benchmark dedicated ESG strategies. The report found that ESG indices may make it difficult for investors to assess whether outperformance is due to an ESG tilt, or simply the result of unintended tilts to traditional factors like growth or value.

ESG Clarity decided to quiz a leading investment consultant about the value of such indices. Simeon Willis, chief investment officer at XPS Pensions Group gave his views on ESG indices and whether there are circumstances where they shouldn’t be used at all…

Q) How useful do you think ESG benchmark indices are for investors?

A) If you have an active manager that is a value manager, you need to have some sort of index to make a comparison and understand the source of any additional return. This would be the case with any factor whether Value, Momentum or Growth.

Having benchmarks is very important, but with ESG, it isn’t so much about “which stock is outperforming” or the features of those stocks, it is more about how fund managers makes decisions, how they engage with companies, and how this affects the underlying portfolios.

Q) Do you think there is any value in specialist indices for ESG investors?

A) I don’t believe that ESG is about excluding companies per se, it is more about a fund manager capturing ESG elements within their overall process. Once they have holdings in companies, they need to recognise the obligations they have to engage with those companies. I believe that, when you hold an investment in any company, there is an obligation to participate in voting and engaging with that company.

Unlike an ethical investment which places strict criteria on that investment, I don’t think ESG is about excluding anything per se. I believe it is more about making sure that, as part of their research, the asset manager is looking at balance sheets, looking at the wider sector, and being mindful of the approach being taken to manage the three, very separate, aspects of ‘E’, ‘S’ and ‘G’.

Q) Do you believe these indices hold more value to ethical investors then?

A) If we are talking about ethical investment, specialist index providers offer a really useful service. They allow people, with views about what sort of companies they wish to hold, to invest without incurring huge costs of active management. They can be great for passive ethical funds and they provide a helpful source of information.

Where, I think, they can be misleading, or confusing, is where people use an ESG index as a basis for ESG management. If you want to be an ethical investor, that is a very specific, and different decision.

Q) Do you believe that ESG indices hold little value to active ESG investors then?

A) I don’t think there is a well-understood or well-designed definition of how ESG should be used within the investment sector. ESG covers a massive spectrum and it is multi-dimensional. In terms of the relevance to investors that are taking ESG into account in their decision making. Indices are not of particular relevance. After all, an index isn’t going to pick up on the value of engaging with a company and it won’t capture any views.

I don’t think people should be employing ESG because they think that their portfolio is going to outperform. I think there is more value in capturing these aspects, than just outperformance alone.

Yes, ESG approaches have outperformed historically, but they may not outperform in the future. But that, in itself, doesn’t mean that the approach has failed. If we place too much emphasis on those stocks that outperform, there will be stocks that aren’t captured by these quantitative screenings.

Q) What do you consider to be the best approach to ESG investing then?

A) We want it to be simple and we want it to be focussed on the right things. The environment we are living in is changing. Therefore, we are having to learn as we go as to how this should be best reflected in investment practice.

The DWP recently ran a consultation on this. We think that it is very important that matters are made simpler and communication clearer. We are trying to keep it very simple.

What is the in best interest of the economy as a whole? To capture these very important non-financial factors and make sure that money flows to the places that are doing well, for the best overall returns we can get.