FTSE Russell Insights

The boundaries of sustainable investment

For many investors, sustainable investment (SI) is still about setting the limits of the universe of stocks or bonds in a portfolio.

SI benchmarks are becoming increasingly sophisticated. They allow investors to build strategies that boost exposure to the future green economy, combat climate change or align equity and fixed income portfolios with new regulations and policy developments.

More prescriptive reporting requirements, improved datasets and analytics are all helping index designers to work with their clients in achieving these goals.

But alongside more data-heavy SI indices, simpler and transparent approaches continue to see demand.

And the oldest of all SI methodologies, the screening of index constituents by their environmental, social and governance (ESG) scores, remains widely used.

Screening methodologies encompass those focusing on the top ESG performers—an approach we call ‘positive selection’—and those excluding certain sectors, issuers or securities for poor ESG performance—which we call ‘negative selection’.

But it was not long ago that the idea of screening portfolios of stocks by constituents’ ESG scores was regarded as a fad.

When FTSE Russell launched its pioneering FTSE4Good index in 2001, the new benchmark was labelled a ‘silly index’ by one of the UK’s leading financial journalists.

But soon most people’s attention turned to who had and who hadn’t met the requisite ESG standards.

When the first FTSE4Good version of the FTSE 100, the UK’s large-cap equity benchmark, was published in the summer of 2001, 66 of the FTSE 100 constituents made the grade. But it was the fact that 34 of the FTSE 100’s constituents had failed to meet the requirements needed to enter the new index that hit the headlines.

The companies left out were involved not just in areas seen as controversial by most people’s standards—such as tobacco, armaments and nuclear power—but also included a leading bank and two of the UK’s largest food retailers.

In several well-publicised cases, companies then reassessed and improved their practices and policies in areas such as social responsibility and environmental standards to meet the criteria for index inclusion.

“FTSE4Good was a ground-breaking index, driving a significant shift in company behaviour. At its launch, the exclusion of Tesco drew headlines,” says Amanda Young, chair of the FTSE Russell ESG Advisory Committee.

“That made companies sit up and take notice that sustainability issues were becoming material for investors. Tesco was swift to respond, improving management practices and disclosures, recognising that what companies do has a wider impact on the environment, their suppliers, employees and societies at large,” says Young.

Whether it’s the positive ESG selection approach embedded in the FTSE4Good index or the exclusionary ESG approach that aims to remove certain activities and sectors, screening is now practised by a number of other leading FTSE Russell benchmarks, including the FTSE Global Choice, FTSE Blossom Japan, FTSE Impact bond and FTSE Fixed Income Global Choice index families.

Choosing the right ESG index constituents

Build investment strategies based on your specific exclusions/ inclusions needs
FTSE Global Choice Equity
FTSE4Good Equity
FTSE Blossom Japan Equity
FTSE Impact Bond Fixed Income
FTSE Fixed Income Global Choice Fixed Income

The same ideas underlie the FTSE Scottish Widows Custom Screened index series, launched in 2022.

Scottish Widows, which as of year-end 2022 looked after around £166bn of savings and investments in the region of over six million customers in the UK, worked closely with FTSE Russell to construct this suite of indices, which are used as the performance target for passive funds with £20bn in assets.

The index rules use the principle of materiality: a (variable) revenue threshold helps determine the point at which companies are deemed unsuitable for investment.

According to the rules, companies deriving more than 10 percent of their revenues from tobacco are ineligible for index inclusion. This threshold ensures that tobacco manufacturers and major distributors are excluded, while industries that may derive a small amount of revenue from tobacco, such as supermarkets, are left in the portfolio.

The FTSE Scottish Widows Custom Screened index series sets thresholds for other proscribed activities: companies that derive more than 5 percent of their revenues from thermal coal or oil sands activities are excluded, as are companies with any involvement in controversial weapons.

In addition, any companies deemed to be non-compliant with the United Nations Global Compact Principles, which cover four categories (human rights, labour, the environment and anti-corruption), are kept out of the index universe.

Large investment institutions like Scottish Widows have an important role to play in engaging with company management to help set behaviour. But the firm still insists on the use of exclusions to set its sustainable investment policy.

“Being a responsible investor means two things to us,” Scottish Widows said in a recent blog.

“First, we have a duty to deliver good investment outcomes for our customers. Second, we should do this in a sustainable way, using our influence to help build a better future for everyone.”

“Whenever possible, we’d rather talk to the senior management of a company if we believe it needs to improve its environmental, social and governance (ESG) performance,” the firm went on.

“If we simply exclude companies from our investments without doing this, we lose the chance to help them evolve into more sustainable businesses, and potentially lose out on any investment gains as a result.”

“But there are some companies involved in activities that cause such harm to society or the planet they pose an unacceptable investment risk. These companies could be hit with large fines, increased costs, or simply fall out of favour with investors and the public.”

Amidst increasing sophistication and complexity in sustainable investment, the idea of setting non-negotiable boundaries for index inclusion remains a powerful one.

In fact, FTSE Russell’s clients tell us they would like to build more robust minimum exclusions into our standard sustainable investment indices: following a market consultation we conducted in 2022, during 2023 we will be introducing a zero-revenue exclusion threshold for both tobacco production and controversial weapons production across those indices.

Discover more about the SI Index framework we follow when helping clients build on investment ideas based on specific exclusions needs aligning to individual values.

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