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Blog Posts — November 1, 2021

Q&A with the IIA and Qontigo: ESG indices need to balance regulatory needs, investment objectives through customized solutions

In July, the Index Industry Association (IIA) presented its first global ESG survey, a poll undertaken to gain a deeper understanding of the evolving role, challenges and opportunities of sustainability investment strategies in the asset-management industry. 

Among key findings, the poll confirmed that sustainability will make further inroads into investment portfolios, and that asset managers view indices as key enablers of this trend and of the integration of ESG data. 

To dig deeper into some of the survey’s takeaways and the future role of ESG indices, we sat down for a conversation with Rick Redding, CEO of the IIA, and Arun Singhal, Managing Director and Global Head of Index Product Management at Qontigo. Below is our exchange. 

Rick Redding, IIA
Arun Singhal, Qontigo

Rick, Arun, the IIA survey shows fund-management companies expect the proportion of ESG assets in their portfolios to rise to over 43% in five years’ time. Where is this ESG trend headed beyond that? How high can that ratio of ESG assets get?

Rick: “The survey speaks directly to this point. It shows that while asset managers currently hold roughly a quarter (26.6%) of ESG elements in their fund portfolios and are expected to hit 43.6% five years from now, that momentum will hold, as funds go over 50% (52.3%) by the end of the decade. That’s a pretty strong growth trajectory. Then there’s the additional point of the extreme imbalance in funds between European and US-based asset managers, with Europe holding roughly 79%, to 12% here in the US. What that means is that adoption in the US is critical in hitting these estimates and has quite a long runway to power this growth trend for years to come. Nearly half (48%) of all US investors reported that ESG would become a lot more important over the next three years and predicted much more rapid growth over the next decade.”

Arun: “In our conversations with clients, we have seen significant and continued interest in sustainable solutions, and we don’t see this momentum slowing any time soon. In Europe, regulation has been a key driver of increased adoption; however, there is also a strong rise in stakeholders’ expectations that investors demonstrate positive societal impact. In November of last year, PwC Luxemburg published a report1 stating that by 2022, 77% of European institutional investors plan to stop purchasing non-ESG products. Further support for the shift to sustainable investing in Europe can be observed in the ETF market. For the first time, net money inflows for European domiciled ESG ETFs were greater than for non-ESG ETFs in 2020. While Europe is certainly leading the way and is an early starter, I believe we are firmly entering a time of global awareness and movement towards sustainable investing. The IIA survey validates this notion with the increase in U.S.-based asset manager responses integrating ESG considerations into their investments. In addition to higher adoption, in my opinion, we are rapidly moving beyond just simple ESG considerations. Additional sustainable investment themes such as climate and the UN Sustainable Development Goals (SDGs) are all of interest to investors and form a significant part of our client conversations.”  

Yet, when it comes to ESG adoption, the survey points to many cited challenges, including lack of standardized methodologies and data. How are indices helping to tackle those problems? 

Rick: “One of the biggest challenges for ESG investors, and for the prospect of greater ESG adoption overall, is the access to more standardized and higher-quality data that can be used to accurately compare company and asset class performance in the ESG categories. At the moment, there are just too many disparate organizations and standards at the international level. Responses in the survey estimated there are currently over one hundred organizations providing ESG ratings. The same goes for improvements needed in reporting and disclosure. Ultimately, enhanced clarity over actual ratings is up to rating agencies and the people that score the companies. But again, the key is better corporate disclosure that would create better quantitative data. For example, in the social or ‘S’ piece of ESG, there’s a lot of qualitative data, which can frankly be subjective to varying degrees. As time goes on, that situation should improve. And as the data quality continues to improve, benchmarks should become more effective in reflecting what investors want — because at the end of the day, it really is about reflecting what investors want. Index providers are not creating the indices for themselves. They’re responding to investor demand.”

Arun: “As an index provider, we work with lots of data every day and understand the challenges that investors face around finding and leveraging robust, high-quality sustainability data. Sustainable investing is diverse in that there are many different goals and investment objectives captured under the sustainability umbrella. While we do agree that, as an industry, we need more standardization in measurement and greater corporate disclosure, we don’t believe that there is a one-size-fits-all solution or that we should be encouraging the use of a proprietary one-size-fits-all dataset. At Qontigo, we have built an open and curated sustainability data architecture. Our research team has spent a significant amount of time evaluating various sustainability providers and has sought to identify the best available data for specific client and investor use cases. We are able to offer our clients integrity and flexibility in tailoring their investment strategies in alignment with their sustainability investment objectives. For example, some of the data providers with whom we have recently developed index solutions for clients include Sustainalytics for ESG concerns, ISS for climate considerations and the SDI-AOP platform for alignment with the UN SDGs. At the end of the day, indices are built based on systematic and transparent methodologies. It is this transparency that allows investors to understand how an investment objective is being met beyond a traditional risk-and-return lens to also include elements of sustainability.” 

Investors, unsurprisingly, say they are struggling to keep up with the barrage of new ESG regulation. Where do you see regulation headed in the next five years: are we going to see more ESG rules imposed on the asset-management industry, or will we enter a period of consolidation and improvement of all recent regulation?

Arun: “We have seen the European Commission lead the way when it comes to sustainable investment regulation. While there has been significant movement driven by regulation, and regulation is needed, it also poses challenges. In Europe, we find regulatory bodies have, at times, issued varied or vague regulatory parameters that have led to different interpretations by our clients and investors. Significant effort by index providers and other market participants is needed to advocate for transparent and consistent regulation as well as to interpret existing regulations. In many countries, regulation is still in its infancy regarding sustainability. Going forward, we hope we are entering a period of regulatory consolidation and increased transparency around the solutions being brought to market.”  

Rick, the survey also confirms the important role played by market indices in ESG investment decisions. Can you comment on some of those key findings? 

Rick: “Indices are very highly trusted by asset managers who use them to evaluate ESG qualities in the funds they create. Eighty-four percent of asset managers across the four countries covered in the survey supported this view. One of the most interesting pieces of this is that at the same time, 89% said data standardization across markets is the biggest barrier to wider ESG adoption. However, indices are currently seen by a clear majority (55%) as the very antidote to this problem, ranking directly alongside internal data as one of the key evaluators and validators of ESG strategies and performance. Investors need to look at the methodologies of any of the underlying indices to make sure those align with their investor preferences. And the survey was very clear in showing that index providers play a key role in that process. But ultimately, they are reliant on the underlying data and rating agencies to help create the indices.”

Arun, are there any specific reasons why investors resort to indices for ESG strategies (i.e., access ESG data, obtain quick exposure, meet regulation?) Or is it rather a combination of multiple factors? 

Arun: “It is a combination of multiple factors. First, traditional market cap-weighted strategies have been available to investors for decades; however, it is only more recently that advancements in data and technology, combined with investor demand for greater transparency, have enabled index-based investment strategies to rise in popularity and accessibility. The advent of the ETF as a cost-effective, tax-efficient vehicle has supported and propelled index popularity. As the ETF market matured, index strategies offered through ETFs expanded and new methods of capturing traditionally active alpha emerged, including the widely popular factor and thematic-oriented index-based strategies. As markets and investor preferences have evolved, so too has the traditional investor toolkit. Return and risk are no longer the only lens through which investors want to analyse, select and evaluate their investments and portfolios. Investors are now also concerned with various sustainability elements, thus creating a natural extension for index development. Second, indices have robust, yet systematic and transparent methodologies. These index qualities offer an element of control in meeting certain investment objectives and enable a standardization for measurement. Lastly, institutional investors have historically led the way in using indices, but the time lag for individual investors adopting more institutional type of strategies is shortening, in part thanks to greater technology. Both the institutional and retail communities are embracing index-based sustainable investing solutions at an extremely rapid pace.” 

That’s very interesting and how do indices play a supportive role in codifying standards and best practices in ESG investing? 

Rick: “Again, it really is about trying to create the best benchmarks and indices based on investor preferences. I think a lot of best practices that apply to market-cap indices will also apply to ESG indices, with the addition of the input data on the ratings that are very important. And it really is up to the investors to understand who is scoring the companies for ESG criteria and the methodologies that the index providers are using, because there are legitimate differences in how rating agencies and data providers score some of these companies. So, the more they understand the ratings and methodology, the more it will reflect their investment decisions and preferences.” 

Lots of things are changing, and fast, in ESG. To finish off, what do you each think will be an important trend or key feature to watch in the next few years in index-based ESG investing?

Arun: “The pace of innovation within the ESG space has been astounding. Clients, whether institutional or individual investors, have access to transparent solutions to meet their sustainable investment objectives. I think this innovation will continue at a rapid pace and we will see more complex products that balance multiple sustainability and risk/return objectives brought to market. For example, many of our recent conversations with institutional clients have combined various sustainability goals – ESG criteria, low carbon concerns and a desire to be aligned with the UN SDGs – with tracking-error considerations and other investment constraints. To meet these multiple objectives, at Qontigo, we were able to leverage our industry-leading Axioma risk model and portfolio-optimization tools. Overall, we are starting to see a shift in client desire from simple exclusionary or enhanced-based screen towards wanting to have a positive societal impact. For example, there is meaningful interest in climate-related indices – historically achieved by lowering the carbon footprint – that position portfolios for an economic transition to net zero. We have also seen strong demand for investing in a manner that is aligned with the SDGs. We believe the search to have a positive real-world impact when investing will only increase. The ability of investors to implement customized investment and sustainable criteria within personalized investment solutions will be an important feature to watch in the next few years.” 

Rick: “There are probably three items here right off the top of my head. One is that I think investors will need to coalesce more around key points in how they evaluate ESG, and whether they want to approach it as just excluding certain types of companies or being more inclusionary of high-scoring companies across the various criteria reflecting more responsible corporate citizenship. Right now, there are so many different indices, and investors have so many different preferences. It’s difficult to see the number of indices declining over the next few years because they really haven’t coalesced around a set of core points or values.

“The second thing you have to realize is that we need to evaluate what the regulatory framework will look like across the globe. While Europeans are out in front of the regulation, the U.S. and Asian regulation will be important insofar as how it develops and how close it is, or how it differs from that of the EU. Because if they differ dramatically, it’ll be difficult to put together global ESG indices that meet potentially inconsistent regulatory requirements. So there needs to be some flexibility in the regulations for ESG that reflect investors’ differing preferences.

“The third key piece is looking at the ‘S’ piece of ESG to see how that develops, because there are some national, regional and cultural differences at play that need to be better reconciled. And investors, again, need to coalesce around those. For example, a lot of the climate benchmarks have goals that are well established globally. It’s the societal piece that is going to be the one that’s most likely to change. We need to find some common ground here before we can get global standards settled.” 

1 ‘2022 – The growth opportunity of the century,’ PwC Luxembourg, November 2020.