This article was initially published in the IPE ETF Guide.
As sustainable investing’s uptake continues to gather pace, index-based solutions have gained investors’ favor as a simple, low-cost and transparent way to implement sustainable strategies. A record USD83 billion flowed into passive sustainable ETFs in the first half of this year, almost three times the amount a year earlier, taking total assets invested to an all-time high of USD293 billion.1
Such growth has come alongside an evolution of sustainable investing objectives, which are now more varied than any other investment style or strategy. For asset owners and asset managers, this increase in popularity offers the ability to truly align portfolios with their individual sustainability goals, and it also means more product options to achieve them.
An ever-evolving range of sustainable strategies
A few years ago, most sustainable investors applied negative ESG exclusions to implement their investment strategy. Today, many approaches go beyond that, incorporating ESG metrics and other sustainability considerations directly into the portfolio construction process. This wide menu includes ESG negative screens, positive ESG integration, ESG best-in-class, Socially Responsible Investing (SRI) and impact investing.
Given this range, it is necessary for investors to undertake proper due diligence to determine whether an existing sustainable offering achieves their investment targets or whether something more customized is needed. For index providers, this heterogeneity means designing solutions that reflect the wide spectrum of sustainable investing demands through both a standard offering and personalized methodologies and data sets that incorporate clients’ unique needs.
Case studies in index design
Recently, Qontigo had the opportunity to work with Eurex, one of the world’s largest futures and options exchange, to design indices that underlie sustainable derivatives. These indices incorporate criteria including ESG exclusions, positive ESG integration and low-carbon considerations, enabling derivatives that align with investors’ responsible objectives.
These innovative instruments have topped EUR3 billion in open interest and have become vital for portfolio managers and traders who need to hedge and manage liquidity in their portfolios without breaching their internal policies. Leading this interest are futures on the STOXX® Europe ESG-X Index, of which over 1 million contracts have exchanged hands this year, making them the most popular ESG derivatives globally.
Qontigo also launched the EURO iSTOXX® Ambition Climat PAB Index last year, which incorporates stringent carbon emission limitations in line with the long-term Paris Agreement targets, integrates leading climate data from ISS ESG and applies screening for controversial activities. The index was selected in July 2020 by 12 pioneering firms to underlie the world’s first fund compliant with the European Union’s Paris-aligned Benchmark (EU PAB) regulation.
Index considerations in the new sustainability-focused landscape
To successfully create or use a passive sustainability solution, it is more critical than ever for investors and index providers to collaborate to determine the right approach that also balances other investment objectives such as tracking error or concentration risks across sectors, countries or even style factors. Just as the thoughtful preparation and audit of any investment strategy is a key part of portfolio construction, so too is the examination of the index firm with whom to partner.
Below we list a few criteria to consider in your evaluation of index providers through the lens of what is required to create a high-quality standard or tailored sustainable investing strategy:
- Customization and flexibility – Does the index provider offer sufficient customization capabilities and demonstrate flexibility in methodology to develop an appropriate strategy for each individual case?
- Analytics and smart portfolio construction tools, including leading modelling and optimization skills – Can you access robust portfolio construction tools and analytic capabilities to effectively and efficiently balance sustainable investment considerations? Do those include equally important criteria such as sector, country and style exposures?
- Open architecture – Will the index operate under an open architecture infrastructure that offers the flexibility to employ specific ESG inputs from one or multiple, independent sources?
- Innovation – Will you be working with a firm that breaks ground in the sustainability space? Do their indices speak to their capabilities as a designer and manager?
- Experience – Does your index partner have a significant track record in developing solutions that have superior design, transparency and simplicity, sufficient liquidity and are compliant with local regulations? Are they a trusted brand in the market?
As sustainable investing continues to become more popular and accessible, the options for investors will only get more and more complex. With their needs turning ever more varied and sophisticated, so will the ways to solve them continue to grow. Investors should be diligent in using the appropriate tools and strategies that accurately match their sustainability goals and in partnering with the right provider to achieve them.
1 Data from ETFGI.