Understanding passive approaches to SRI

Index funds are easier for investors to access, but a large amount of new product development is being driven by ETF issuers, with ETFs becoming one of the most popular vehicles of access for SRI investors due to their transparency, liquidity, accessibility and low costs.

Assets in Ucits ETFs tracking SRI indices increased from $6.2bn at the start of 2017 to $14.3bn today, marking a rapid rise for ETFs as an SRI allocation tool. 

Index selection for passive investments

Once an investment wrapper has been chosen, asset managers and investors alike have the difficult job of then choosing the index they want to track, with SRI indices generally categorised into three types: negative, positive and thematic.

Negative/exclusions-based indices are the oldest and, historically, the most prevalent indices for SRI investors.

There is $15trn invested globally in indices that use exclusion criteria, representing over 65 per cent of overall SRI assets.

These indices generally exclude stocks from existing investment universes based on what they produce, how they operate and where they generate their revenues.

The most common form includes exclusions based on involvement in nuclear weapons, cluster munitions and landmines, but indices exist based on criteria ranging from alcohol to stem-cell research. 

Positive screening, also known as best in class or ESG integration, focuses on investing in stocks with superior ESG performance relative to regional and industry peers.

Strategies excluding the bottom performers, overweighting the best performers, or overweighting stocks that are significantly improving with regards to ESG metrics, fall into this category, with examples including the MSCI ESG Leaders indices.

Finally, thematic indices are the newcomer to the SRI index space, representing a fraction of overall assets.

While investors are increasingly seeking to improve the ESG metrics of their portfolios, many do not want this to come at the cost of tilting the underlying exposure significantly away from the original, non-ESG index.

These indices target specific ESG issues, only including companies with minimum scores in certain areas, or companies that derive a certain amount of revenue from particular activities. Examples include gender diversity indices, or climate change-based benchmarks.

The majority of ESG indices, especially those based on positive or negative screening, are based on a parent index, with stocks removed and/or re-weighted to form the ESG version. These types of indices are used extensively by ETFs. 

For example, to attain ESG-tilted developed market global equity exposure, the starting point could be the MSCI World index, which comprises 1,644 companies as of 31 May, 2018.

For the MSCI ESG Leaders indices, MSCI first applies a number of negative screens to the 1,644 stocks, excluding companies with involvement in certain controversial industries, including nuclear power and weapons.