online fashion portal Boohoo
Boohoo, the UK retailer that last year was engulfed in a scandal over workers’ rights, was given a moderately high ESG rating compared with several peers that one index provider deemed to have ‘bigger problems’ © AFP via Getty Images

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Behind the scenes in the investment industry, a battle is playing out: index providers are vying with each other to provide the benchmarks needed to meet demand for sustainable funds.

In Europe, flows into exchange traded funds that focus on environmental, social and governance factors outstripped flows into all other types of ETFs in the first quarter of this year, Morningstar data showed.

Globally, the assets under management in ESG funds have ballooned from $10bn in 2015 to $246bn as at the end of March, according to ETFGI, the data provider. Meanwhile, the number of ESG ETFs has jumped from 90 globally in 2015 to 578 today.

With investor appetite for sustainable ETFs soaring, index providers have rushed to grow their range of indices, often buying up specialist data providers or investing in internal tools in anticipation of ESG benchmarks becoming more lucrative.

Aaron Yoon, professor in accounting and information management at Kellogg School of Management, says index providers “see value in ESG”.

“It is too big to ignore these days,” he observes. “These indices now understand it is going to be a big business and are putting a lot of money into how to best do it.”

But, as demand for the indices rises, there are growing concerns about how they are compiled. Some critics have questioned why companies appear in certain benchmarks but at the same time are shunned by others — as well as whether ESG indices really are a sustainable investment option at all.

Many of the first ESG indices were specialist in nature, focusing on companies tackling water scarcity and developing clean energy. In recent years, however, there has been a shift towards more generic indices that purport to provide an offering similar to traditional benchmarks, such as the S&P 500. This change came as fund managers told index providers of the growing market of investors who desired mainstream investments but with a sustainability tilt.

According to data from ETFGI, the MSCI USA Extended ESG Focus Index is now the largest benchmark in the sector globally. ETFs with some $15.5bn in assets track the index, although the total could be larger when all index funds are included. Other popular broad ESG indices include the MSCI Emerging Markets Extended ESG Focus Index, the FTSE US All Cap Choice Index and the S&P 500 ESG Total Return Net.

Specialist indices also rank highly in terms of assets under management, according to ETFGI, including the S&P Global Clean Energy Index and the MAC Global Solar Energy Index.

But many popular sustainable indices receive a low score for ESG, research from TrackInsight, the data provider, shows. While ETFs tracking the S&P Global Clean Energy Index received an A+ score from TrackInsight, others, such as those replicating the MSCI USA Extended ESG Focus index, were given a C+ (D is the lowest score).

There are also questions around whether appropriate companies appear in ESG indices. Last year, several fund managers attributed their holdings in Boohoo, the UK retailer that was engulfed in a scandal over workers’ rights, to the company having been included in the benchmark indices they were tracking.

Nizam Hamid, an independent index and ETF consultant, says there is “no common model for defining how a company meets ESG criteria”, partly because different investors prioritise different aspects of sustainability.

Instead, each index provider has a “secret sauce” when it comes to how they compile their indices and assign a score to a company. For example, Hamid says MSCI has 10 themes and 37 factors it considers when developing a score for a company, while FTSE Russell has 14 themes, and S&P has 23 criteria.

“That gives you a very wide variation for the same company by different providers,” notes Hamid. “A company could be highly rated for one, but not at another.”

Remy Briand, head of ESG at MSCI, says its company ratings are sector specific. This means that, in energy and mining, for example, there is a greater focus on the environmental impact, while in retail there is emphasis on the supply chain, and in technology, on cyber security and privacy.

MSCI also ranks companies relative to their peers. Boohoo therefore had a moderately high rating compared with other retailers because there were some in the sector that had “bigger problems” when it came to ESG, explains Briand.

MSCI and S&P have different methodologies for how indices are constructed, as well. This means that it is possible to have two benchmarks that both notionally cover Europe, but with very different companies included.

“It is difficult for a lot of end investors to see their way through all the variations and that creates a challenge for index providers and fund providers,” says Hamid.

But despite the growing pains, Reid Steadman, managing director and global head of ESG indices for S&P Dow Jones Indices, says there is “good momentum” in demand for ESG indices.

“This is still a nascent area,” he says. “This is not a short-term trend. I have been in product management roles where I have seen themes come and go. But this is really one that is part of a mega trend.”

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