Historically, market capitalization-weighted indices have been the tool for asset owners to benchmark and construct their investment portfolios. Gauges including the STOXX® Europe 600 Index are tracked by billions of euros, and provide the most accurate representation of the broad and diversified equity market that these investors target.
Yet, as asset owners step up their fiduciary role of responsible investors, they are looking for solutions beyond the traditional market cap-weighted index. In implementing environmental, social and governance (ESG) principles, investors are creating portfolios that diverge from standard benchmarks, leading to tracking error and additional management costs.
For these portfolios aligned with responsible policies, pursuing a passive strategy hasn’t been a straightforward option. The negative screening of ESG offenders, the most-followed responsible-investing strategy, leads to constituency mismatches with benchmarks. The integration of ESG factors into fundamental stock analysis, on the other hand, has resulted in many customized indices and lack of standardization.
A standardized ESG exclusion approach
To address this shortfall and comply with standard responsible policies of leading investors, STOXX is launching the STOXX® Europe 600 ESG-X Index, a version of Europe’s popular benchmark that excludes companies based on norm- and product-based screenings.
The new index tracks the STOXX Europe 600 Index minus those constituents involved in certain activities. These include businesses that produce or distribute controversial weapons, are tobacco manufacturers, generate or consume thermal coal, as well as those in breach of any of the 10 United Nations Global Compact principles of human and labor rights, the environment, business ethics and anti-corruption.
Advanced screening on coal
For thermal coal, the methodology advances the screening by excluding companies that partly derive revenue from its extraction or exploration, but also those that utilize it to generate more than a quarter of their power output. The exclusion screens are provided by leading ESG research firm Sustainalytics, whose data help design a systematic and rigorous stock-level analysis.
As of late 2016, around $15 trillion were managed globally under negative or exclusionary screening strategies,1 followed by $10.4 trillion in the ESG integration strategy and $8.4 trillion in corporate engagement.
ESG vs. market cap-weighted strategies
STOXX has been facilitating responsible investing since 2011 with indices that select the best-in-class performers on ESG metrics, targeting a sustainability-weighted strategy. The STOXX Europe 600 ESG-X is the first ESG exclusion-screened version of a flagship index, in this case a liquid market cap-weighted benchmark for the European market.
The STOXX Europe 600 is a broad, yet highly tradable index that provides access to the pan-European equity market. The STOXX Europe 600 ESG-X shares its benchmark’s rules, sector composition and methodology – including the same transparent free-float market-cap weighting scheme. This results in a similar risk-return profile and a low tracking error, and enables familiarized investors to easily implement and adopt an ESG-screen strategy.
More than 1 million STOXX Europe 600 Index futures trade, on average, every month on Eurex, and there are listed options and futures on STOXX Europe 600 Index sectors. This facilitates equity portfolio tasks such as hedging, tactical adjustments and liquidity management, and can help lower the cost of trading.
The STOXX Europe 600 ESG-X Index is suited to underlie derivatives, structured products and exchange-traded funds, as well as asset owners’ mandates.
A fast-exit rule in the new index secures a swift response to any ESG breach by quickly removing offenders, limiting investors’ risks.
The role of indices in the ESG transformation
With sustainable investing steadily gathering pace, all participants in the asset-management industry are responding with innovation and focused capabilities.
Exclusion criteria can be considered a very basic and simple step for asset owners looking to disassociate themselves from activities that are detrimental to our societies and environment, but it is a fundamental one on the ESG transformation path of the financial and corporate landscape.
In this process, passive investing can help attain that goal via ready-made approaches that are as simple as they are accurate and transparent, and in this case, preserve the established market cap-weighted strategy framework that most asset owners adhere by.
1‘Global Sustainable Investment Review 2016,’ Global Sustainable Investment Alliance (GSIA).