LGIM – Index investing: lifting the lid on ESG integration

By Fadi Zaher, Head of Index Solutions

Index investing is not passive investing. Yet a conflation of the two concepts sadly persists despite the numerous observable ways in which index investors are not necessarily passive: they proactively allocate in and out of funds, they select strategies that adhere to proactively designed methodologies, and this in turn can reinforce the already proactive use of their voting rights.

It is worth emphasising this distinction between index and passive investing because it helps debunk the myth that index investors cannot be responsible investors. Even setting to one side the role index investors can play as active owners in equities, it is clear that they make proactive decisions about what they own. One such proactive decision can be to integrate environmental, social, and governance (ESG) considerations into their index strategies.

Just as investors in the S&P 500 index have historically made the proactive decision, implicitly or explicitly, to exclude *Tesla – a stock that has grown larger than the likes of *JPMorgan Chase, *Walt Disney, *Walmart, or *Pfizer – so index investors can reflect ESG criteria.

We believe this can make a genuine difference to portfolios. For example, through their choice of strategy index investors can:

• Eliminate their exposure to businesses that conflict with their own values.

• Reduce the amount of carbon emitted by the companies in their portfolios.

• Allocate more of their capital to firms that have more diverse executive teams or stronger governance.

However, it must be remembered that in index investing, what you want to achieve can only be understood in the context of how you intend to achieve your desired outcome. Index funds are rules based, and for ESG strategies investors must understand how those rules have been structured.

The power of three

There are generally three methods for integrating ESG criteria into an index.

Exclusion: Historically, the exclusion approach – or negative screening – has been the most widely used to avoid specific stocks or industries in an index. The most prominent exclusions have tended to be tobacco, alcohol, gambling, fossil fuels, and weapons. The advantages of this type of approach are that it is transparent and tends to give a guaranteed impact and peace of mind if an investor’s ultimate objective is to remove exposure to specific securities and sectors.

However, this type of integration also tends to alter the profile of the portfolio quite significantly if the sector or issuer excluded has a material weight in the parent index.

Consequently, with more exclusions, the index tends to deviate from generating market-like returns and to some extent a market-like risk profile as investors are inevitably taking on tracking error or active risk from the market.

Exclusions also remove the possibility of the asset owner engaging with issuers to change their behaviour and hold companies accountable for any sustainability risks.

Optimisation: This approach aims to maximise the ESG score or rating of an index. This can be helpful for investors looking to identify companies that are setting the standard in ESG criteria and practices, or companies that have committed to moving toward best practices. Unlike the exclusion approach, optimisation tends to overweight and underweight securities – rather than removing them – to achieve an ESG outcome subject to tracking-error targets or an active-risk budget.

Furthermore, optimisation can also be quite efficient when applied to an index solution that requires meeting multiple objectives simultaneously, such as adhering to Climate Transition and Paris-aligned benchmarks. For example, an index optimised for these objectives may have constraints including:

• a tracking-error target;

• reducing carbon intensity by 50% from inception and by a further 7% every subsequent year;

• specific or general sector deviations of no more than 1% relative to a benchmark.

Tilting: The tilting approach simply allocates more capital to companies with higher ESG scores and less to companies with poor ESG scores. This capital allocation can be based on various techniques such as deciles of ESG scores, whereby the lowest deciles have their index weight downgraded by 80% and the top decile obtains twice the capital allocation of the original weight in the index.

At LGIM, we believe tilting provides a compelling blend of impact, transparency, and market exposure

Important Information: Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Views expressed are of LGIM as at 01 July 2020

The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) *is not a recommendation to buy or sell securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272.

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