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ESG Indexing is Evolving as You Read This

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Despite the rapid growth of sustainable investing in recent years, investors and asset managers must overcome a lack of clear standards if the industry is to achieve scale. And make no mistake, the growth is exceedingly rapid – BlackRock is projecting global Sustainable ETF assets to grow to $400 billion by 2028.

There is good news regarding the need for clear standards, however. The emergence of more sophisticated environmental, social, and governance (ESG) research and increased ESG reporting by public companies have created the potential for increased structure and standardization.

Among the prime beneficiaries of the enormous quantities of ESG data and research are ESG-based indexes, which, as benchmarks, help define both the ESG and market structure around sustainable investing. As a result, the investment solutions that seek to track them can provide cost-effective, standardized alternatives to what has been considered the norm, i.e. customized, potentially higher-cost investments that may not be accessible to many investors. Right before our very eyes, ESG indexes are becoming essential building blocks of asset allocations for institutional, wealth management, and personal investors.

A new report from iShares examines the evolution of indexing as a tool for sustainable investing over the past three decades, the explosion of data that has led to the development of ESG ratings, and the use of ESG ratings in the construction of ESG indexes that find their ways into today’s portfolios. The paper includes case studies that illustrate how some investors are applying ESG indexes in pursuit of both financial and sustainable objectives.

Why ESG indexing matters

Indexing makes markets more accessible, credible, and structured for investors – and the indexes themselves act as performance benchmarks, the basis for passive investment funds such as ETFs, and investment policy benchmarks for large asset owners such as pension funds. In addition to these traditional applications, ESG indexes also define universes that meet specific ESG criteria for use by asset managers, and standards for ESG characteristics to compare with the underlying market.

Investment decision-making benefits from ESG indexes, too – their evolution has driven improvements in ESG research, enabling the transition from investment committees making qualitative judgments to leveraging ESG ratings that support consistent, transparent index decisions.

Ratings help inform investment decisions

A mainstay of the ESG research ecosystem are ESG ratings, which are intended to help investors gain a better understanding of the ESG-related risks and opportunities facing companies. They have evolved considerably in the past decade in response to demand from investors and the growing availability of data. ESG ratings address information about companies that is not reported in standard accounting frameworks — information BlackRock believe is material to informed investment decisions. As the primary tool of ESG integration, ratings are the foundation of many ESG indexes and a critical differentiator in distinguishing such indexes from traditional broad market benchmarks. It is the introduction of ESG criteria into security selection that sets ESG indexes apart. Otherwise, they are governed with similar types of policies and procedures as traditional indexes.

ESG indexes provide transparent, rules-based, and cost-efficient exposure to companies with particular ESG characteristics. A case study in the iShares report focuses on the MSCI Extended ESG Focus Indexes, which are designed to maximize exposure to companies with high ESG ratings while exhibiting risk and return characteristics similar to those of the underlying market. The indexes utilize optimization to maximize portfolio-level ESG scores while limiting predicted tracking error relative to the parent index. This approach, which balances achieving a risk and return profile close to the parent index while also tilting towards companies with higher ESG ratings, allows an investor to more closely meet their asset allocation objectives and achieve a more sustainable outcome – and it’s a superb example of how ESG indexing is evolving to meet investors’ needs.

Read the full report.