Blog Posts — August 30, 2019

New Study Looks at Impact of ESG Exclusions Across Regions

In May, STOXX introduced a fully-fledged ESG-X Index family comprised of versions of established benchmarks that exclude companies based on standard environmental, social and governance (ESG) principles. 

The ESG-X Indices implement negative screening based on norms (United Nations Global Compact principles) and products (controversial weapons, tobacco and thermal coal), and aim to meet investors’ need for market-capitalization-weighted benchmarks that are in line with their responsible-investing policies. 

To assess precisely what the implication of these exclusions are on a portfolio’s risk and returns, a new research paperby Anand Venkataraman, STOXX’s Head of Product Management, and Ladi Williams, Product Manager, examines six STOXX key ESG-X indices: STOXX® Europe 600 ESG-X IndexSTOXX® USA 500 ESG-X IndexSTOXX® Global 1800 ESG-X IndexSTOXX® Global 3000 ESG-X IndexSTOXX® Japan 600 ESG-X Index and EURO STOXX 50® ESG-X Index.

The paper looks at each index from five different perspectives, covering comparative returns, performance analysis, effect on industry weights and stock constituency, performance impact of each exclusion, and factor contribution.

Impact analysis

For example, between March 2012 and June this year, the STOXX Global 1800 ESG-X Index outperformed its benchmark by 12 basis points over the entire period.The granular analysis shows that this outperformance was the net result of accruing extra returns from UNGC, tobacco and coal exclusions, while sustaining a drag from controversial weapons exclusions.  

The outperformance came with slightly higher volatility. Both the STOXX Global 1800 ESG-X Index and its benchmark, however, show the same Sharpe ratio over the period.

In general, and across regions, exclusions due to controversial weapons have often resulted in a drag on returns, while exclusions based on Global Compact principles have tended to be accretive to performance. 

Effect on industries’ weight

During the period analyzed, the share of each benchmark affected by the exclusions has varied, the study showed. This ranged from an average weight of 9.2% being screened out from the STOXX USA 500 ESG-X Index relative to its benchmark, to an average weight of only 2.4% in the STOXX Japan 600 ESG-X Index relative to the STOXX® Japan 600 Index. 

In terms of industries, the exclusions have tended to result in significant underweights to the personal & household goods (from tobacco exclusion) and industrial goods & services supersectors (mainly from controversial weapons exclusion). There has also been underweights in utilities from thermal coal exclusion. 

Exclusions due to breach of UN Global Compact principles have often resulted in underweights to the banks and healthcare supersectors, the analysis found. As is the case with other sections of the analysis, industry weighting results varied from region to region.

A comprehensive look into performance, volatility, Sharpe ratio and drawdowns of the six indices helps highlight any deviation from the benchmark and calculate the cost of applying ESG screens.  

Factor-based performance attribution 

Furthermore, the study’s authors carried out a historical factor-based performance attribution analysis of the ESG-X indices. This approach looks at the attribution of the active returns of the ESG portfolio, and the contribution from factors including style, country, industry, currency and market. Sub-factors such as leverage, size, exchange-rate sensitivity, momentum, growth and volatility are also scrutinized.  

Because the ESG-X indices have similar risk-return profiles to those of their benchmarks, they have been conceived as a simple replacement for existing indices in core portfolios. The availability of a futures market for indices such as the STOXX Europe 600 ESG-X Index additionally helps to efficiently and more cheaply manage an ESG-benchmarked portfolio. 

Overall, the paper confirms that the ESG exclusions tend not to cause any statistically significant divergence on returns or a portfolio’s risk profile. However, there are differences from region to region, and tracking error, biases and exposures — albeit relatively small and often immaterial — emerge as a result of implementing the screens.

These findings provide important information for investors seeking to align their portfolios along responsible lines. 

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Venkataraman, A., Williams, L., ‘STOXX® ESG-X INDICES,’ STOXX, August 2019.
Gross return in dollars, Mar. 16, 2012 – Jun. 28, 2019.