By David Harris, Head of Sustainable Business, LSEG
When it comes to sustainable investment, investors are subject to a range of sometimes competing pressures. They increasingly recognize the long-term, risk-return benefits of integrating climate or broader ESG analysis. They see the advantages in exercising their rights as shareholders, through active ownership, to encourage better sustainability performance. They want to demonstrate positive impact.
Further, many investors also want to harvest the benefits of low cost diversified return that broad passive index portfolios offer, which militates against one of the most powerful responsible investment tools – that of ”exit." Meanwhile, active ownership can be resource intensive especially where it involves engagement across hundreds or even thousands of companies across broad and diversified portfolios; in an environment characterized by relentless pressure on costs, these resources can be difficult to find.
However, passive index tracking can be combined with "rules-based scale engagement"—where transparent index rules combined with direct corporate engagement on the assessment methodology delivers improved sustainability performance and measurable impact for passive investors.
Indeed, we would go further: not only is passive investing able to make new approaches to active ownership possible, it could—given the rapid growth in sustainability and climate benchmark adoption investing—become one of the most important mechanisms by which investors drive changes in corporate sustainability practices. This does not replace the type of deep and more bespoke engagement conducted by asset managers but indexes can reinforce and complement engagement strategies.
A recent paper from FTSE Russell makes the case that the roots of engagement through ESG indexes can be traced back to the launch of the FTSE4Good Index in 2001. One of the world’s longest running sustainable investment index families, FTSE4Good is a series of best-in-class sustainability indexes comprised of companies that meet a variety of environmental and social thresholds. These thresholds are designed to become more stringent over time, based on a transparent process and guided by an independent committee of experts. As these thresholds rise, FTSE Russell analysts communicate and engage with existing and potential constituents to ensure they understand the changing requirements. Companies whose performance fails to meet the thresholds are given a grace period to improve, before being removed from the index if they do not.
FTSE4Good has led to measurable outcomes. Academic research has shown how the ratcheting up of requirements and the associated engagement with companies has led to improved practices across a wide range of sustainability areas. Over the years this has included themes on including supply chain labor standards, climate change and tax transparency. Sector-specific requirements have also had an impact. Tighter criteria around breast-milk substitute marketing led to changes in marketing practices at major infant formula manufacturers. Country indexes and collaborations with specific stock exchanges has also been effective in deepening corporate engagement in South Africa, Japan, Malaysia, Taiwan and Spain. Sustainability indexes are attracting growing assets under management. This, alongside the reputational benefits of inclusion and demerits of expulsion, provides a strong motivation for company management to improve their sustainability performance in line with index requirements.
The rapid growth of smart beta styled sustainability indexes (“Smart Sustainability Indexes”) makes an even stronger access-to-capital case for engagement via passive indexes. Smart beta is an approach to passive index construction that weights or selects index components on metrics other than market capitalization, such as size or value. These metrics can include sustainability considerations, such as emissions per unit of revenue or workforce diversity: FTSE Russell’s latest annual survey of asset owners found that 58% anticipate applying sustainability considerations to smart beta strategies, up from 44% in 2019.
As we have previously noted elsewhere, for index-based engagement to work, it is important that companies understand the rules and the dynamics at work. We would suggest that, at present, there is often limited understanding among companies about how the ESG data they produce is used by investors, including in index investing. There is clearly a need for better communication on this front to ensure that index design informs companies’ sustainability strategies and performance. But where this communication is focused, it can be powerful and, when paired with index design, can allow passive investors to benefit at minimal cost from impactful engagement processes.
This is the case with the Transition Pathway Initiative (TPI), through which a group of asset owners is working together to assess the extent to which companies are addressing climate risk and working together to engage those companies to improve. The analysis is also used to construct the FTSE TPI Climate Transition Index, which tilts the constituents of the FTSE Developed Index towards strong performers on climate, and away from laggards. The TPI analysis also provides a core component of the data feeding into the Climate Action 100+ which is backed by investors managing more than $50 trillion in assets.
The motivation for companies to take action to investor engagement will be amplified by the extent to which investors are backing indexes linked to their climate performance. The index offers a clear mechanism by which passive investment and active ownership can be brought together to offer synthetic engagement at low cost.
Register here for a discussion around achieving scale in active ownership and engagement through index investing
© 2021 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.