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Sustainability goes smart

We tend to look back at the past and marvel at the changing trends in clothes, food and entertainment. Trends in investment decisions can also undergo quite radical change, although usually for more fundamental reasons than simply personal taste. The FTSE Russell Smart Beta 2017 Global Survey Findings from Asset Owners report has revealed growing interest in both smart beta and sustainability investing over the last few years. As asset owners have become increasingly interested in these two areas, the idea of merging the two gained momentum. Is there a way to combine the two approaches that could maximize the desired exposures to each?

In November 2016, FTSE Russell launched our first "smart sustainability" index—the FTSE All-World ex Controversial Weapons Climate Balanced Factor Index. This index is constructed using the FTSE All-World Index as a base, applying both climate and factor adjustments. As the table below demonstrates, the smart sustainability index first excludes some controversial exposures and then uses three sustainability parameters and four factor tilts. The result is a single index designed to maximize the desired factor and sustainability exposures.

Smart Sustainability framework construction

Source: FTSE Russell.

The chart below illustrates how integrating the two considerations into one index can maximize the desired exposure to each. In this example, the desired exposures are to the value factor and to low operational carbon emission. In the first column — a value factor index alone — the exposure to value is high but exposure to low carbon emission companies is reduced. In the second column, we see what happens to exposure if the focus of the index is solely on carbon emission reduction: there is increased exposure to low carbon emission companies with little effect on exposure to the value factor. Now let’s see what happens when we combine the two.

Factor exposure and sustainability interactions

Source: FTSE Russell Data as at May 22 2017. For illustrative purposes only.

The third column in our example above shows that by creating a composite of the value factor index and the low carbon emission index we can increase exposure to both the value factor and to low carbon emission companies. However, in a composite of two independently designed indexes there is compromised exposure to both value and low carbon emission and we would expect some inherent counteraction to occur. To avoid this pitfall, the smart sustainability index uses a system of sequential tilts applied consistently to the risk premia factors as well as to sustainability parameters within a single index. And indeed, in the final column we see that the single index approach does increase the desired exposures to both the value factor and the sustainability parameter. 

The combination of these two popular considerations appears to yield a more efficient means of accessing the desired exposures. FTSE Russell aims to provide indexes that can address the evolution of asset owners’ investment preferences ­towards a more sophisticated approach to sustainability investing than in the past.

Please see our website for more detail on the 2017 Smart Beta Survey. For more detail about smart sustainability, listen to our recent webinar. See also the video by Mark Makepeace, CEO of FTSE Russell, on ESG benchmarking and asset owners' increasing focus on ESG.



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