Recent years have witnessed two major trends among professional investors.
The first is increasing interest in environmental, social and governance (ESG) questions. The second is rising allocations to ‘smart beta’, a catch-all term referring to investment strategies where the underlying index departs from the standard method of weighting constituents by their market capitalisation.
These trends have now come together in the form of smart sustainability indexes, which allow investors to implement sustainable investment strategies with greater sophistication than in the past.
When FTSE Russell launched its FTSE4Good index in 2001, the story hit the headlines, although not all comment was favourable.
For many, the concept of using an index to help investors allocate their funds according to ethical principles was a step too far. Many dismissed FTSE4Good as a marketing gimmick. One UK newspaper called it the “silly index”.
It is fair to say that, among professional investors, ESG issues were regarded by some as niche concepts that were irrelevant, distracting and potentially detrimental to returns. Yet the idea of investing sustainably has more than stood up to the test of time. Nearly two decades later, the investment landscape has changed beyond recognition.
Financial institutions around the world – including pension funds, insurance companies, asset managers and banks – now incorporate sustainable approaches into their in-house investment philosophy and processes as a matter of course.
According to FTSE Russell’s 2018 Smart Beta survey – which polled 185 large investors from around the globe, with estimated total assets under management in excess of $2tn – ESG topics are now part of investment strategy discussions at more than half the world’s institutions (see Figure 1).
Even in the US, traditionally a laggard in ESG adoption, nearly two in five asset owners now consider sustainability as central to portfolio construction.
This trend has been reinforced by supranational and national legislation and directives designed to limit global warming, improve working practices and strengthen corporate governance.
A central initiative in relation to climate change was the 2015 Paris Agreement, which aims to limit increases in global average temperature to a maximum of 2°C above pre-industrial levels.
At the same time as interest in ESG is on the rise, so are adoption rates for smart beta. FTSE Russell’s annual smart beta surveys show a rise in allocations to non-traditional index strategies, from 26% of the sample in 2015 to 48% in 2018. Investors’ stated motivations for using smart beta include return enhancement, risk reduction, improved diversification and cost savings.
A majority of those using smart beta told FTSE Russell they allocate to this type of strategy for the long-term, as well as using more than one smart beta approach. As a result, there is growing interest in integrated smart beta approaches, which achieve different risk reduction, factor or sustainability objectives consistently.
Smart sustainability indexes represent the logical outcome of these two trends; 38% of asset owners worldwide, and more than half those in Europe, told FTSE Russell they anticipate applying ESG considerations to a smart beta strategy (see Figure 2).
But how does smart sustainability work in practice?
As an example, take the FTSE All-World ex CW Climate Balanced Factor indexes, which follow transparent rules.
The first step is to screen stocks for their exposure to common ‘factors’, or shared characteristics. In this case, four ‘tilts’ (volatility, quality, value and size) are applied to the index weights of a starting universe of stocks, producing a portfolio with exposure to all four factors.
This smart beta approach is then integrated with three climate parameters. The parameters reduce the index’s exposure to companies with high fossil fuel reserves or carbon emissions, while increasing exposure to companies exposed to a low-carbon economy, as measured via FTSE Russell’s in-house ‘green revenues’ model.
The outcome is an index that achieves two results simultaneously: smart beta exposure and a screen for sustainability. Smart sustainability indexes therefore meet the demands of many global asset owners by helping them to express their investment beliefs in a succinct and logical manner.
Henry Odogwu, managing director, head of asset owner group, Europe, FTSE Russell
Column sponsored and supplied by FTSE Russell