The term ESG emerged in a 2004 study titled, “Who Cares Wins,” which had the tag line, “connecting financial markets to a changing world.”
The report read, “A better inclusion of environmental, social and corporate governance (ESG) factors in investment decisions will ultimately contribute to more stable and predictable markets, which is in the interest of all market actors.”
Over these years, the bridge between ESG and investing has grown stronger. Globally, ESG-focused funds witnessed a record inflow of $649 billion during the first eleven months of 2021, much higher than $542 billion and $285 billion recorded in 2020 and 2019, respectively. Overall, 10% of worldwide fund assets are held in ESG funds.
This shows that investors are increasingly showing their commitment to ESG. However, a PwC survey conducted in September 2021 said that “many described significant reservations about the quality of the information available to them when evaluating ESG priorities, including information on the carbon emissions of their investments.”
Thus, to ensure that ESG truly represents what it stands for, entities will have to work to become more and more transparent going forward. Understanding the construction of indexes and selection process of constituents can be one step in that direction.
Here’s a look at three ESG indexes (based on the prominent parent indexes) and the ways to invest in them.
1. MSCI USA Extended ESG Focus Index
The MSCI USA Extended ESG Focus Index launched in March 2018 and is based on MSCI USA Index, which includes securities across the U.S. equity markets. The index is constructed by selecting constituents from the parent index through an optimization process that aims to maximize exposure to ESG factors for a target tracking error budget set to 50 bps under certain constraints. The index is sector-diversified and targets companies with high ESG ratings in each sector. Companies related to segments such tobacco, controversial weapons, producers of or ties with civilian firearms, thermal coal and oil sands are not eligible for inclusion. The MSCI USA Index has 628 constituents while its subset MSCI USA Extended ESG Focus Index has around 321, which means an exclusion close to 49%. The USA Extended ESG Focus Index returns have closely followed the returns of the parent index over the years, and in 2021, both indexes posted 27% returns.
The index is tracked by iShares ESG Aware MSCI USA ETF (ESGU), which is one of the largest ESG funds. Launched in 2016, the iShares ESG Aware MSCI USA ETF tracks the MSCI USA Extended ESG Focus Index to obtain exposure to large- and mid-cap U.S. stocks with favorable ESG practices. The fund has $25.48 billion as assets under management and an expense ratio of 0.15%. The top ten constituents currently add to 27.75%.
2. Nasdaq-100 ESG Index
The Nasdaq-100 ESG Index, launched on June 21, 2021, is designed to measure the performance of companies included in the Nasdaq-100 Index that meet all ESG measures. Compared to the other ESG indexes, Nasdaq-100 ESG Index bears greater similarity to its parent index, Nasdaq-100, in terms of its constituents. This is largely because the Nasdaq-100 Index itself has a strong foundation in ESG and the majority of the constituents present in Nasdaq-100 already have sound ESG scores. Given the compelling ESG narrative of the parent index, the exclusion rate from the index is just around 6%. The ESG index has a screening process that considers 15 problematic areas of business activity at the company level. During 2021, the ESG version posted 30.57% in returns.
Investors can get exposure to the Nasdaq-100 ESG Index by investing in the Invesco ESG Nasdaq-100 ETF (QQMG), which was launched in November 2021. At the time of launch, Executive Vice President and Head of Investment Intelligence at Nasdaq Lauren Dillard said, “the interest in integrating ESG considerations into investment portfolios is on the rise globally. We are pleased to work with Invesco to introduce a refined and ESG-friendly version of one of the world’s most preeminent benchmarks.”
The fund has 94 constituents, with the top ten currently adding to 52.27%.
3. S&P 500 ESG Index
The S&P 500 ESG Index is a broad-based, market-cap weighted index that is designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P 500. The index excludes companies with disqualifying UN Global Compact scores and business involvement in tobacco, controversial weapons and thermal coal. It then targets 75% of the float market capitalization of each industry group within the S&P 500 using an ESG score as the defining characteristic. The index was launched in January 2019 and has 319 constituents, which translates to around 38% exclusions from the parent index. The S&P 500 ESG Index reported returns 3.07% more than the parent index in 2021.
The index is followed by Xtrackers S&P 500 ESG ETF (SNPE). The ETF was launched in June 2019, and currently has $881,226,005 as assets under management and an expense ratio of 0.10%. The top ten constituents add up to 36.43% and currently include:
Disclaimer: The author has no position in any stocks mentioned. Investors should consider the above information not as a de facto recommendation, but as an idea for further consideration. The report has been carefully prepared, and any exclusions or errors in it are totally unintentional. Index and ETF data based on January 13, 2022 and is subject to change.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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