Vanguard’s approach to ESG investing
Investments you can believe in
Commentary by Joao Saraiva, Senior Investment Analyst, Investment and Product Analytics, Vanguard Europe.
Index funds and ETFs that align with investors’ environmental, social and governance (ESG) preferences are rapidly growing in popularity with industry cash flow into ESG indexing products in Europe totalling more than $21 billion during the third quarter of 20221.
The growing universe of ESG index funds encompasses a wide variety of approaches to incorporating ESG considerations in a portfolio. ESG index funds and ETFs track indices which can be based on a range of rules, and some investors may find these methodologies difficult to understand. These rules dictate what is included in the index (and how much exposure to allocate to the included securities) as well as what is excluded. This will determine how diversified a portfolio will be when based on such a benchmark, and ultimately, how it performs.
Confronted with these broad choices, it’s important for investors to understand how their chosen ESG index fund works and whether they are getting the diversification they expect.
Choosing an ESG index fund which is aligned with an investor’s preferences is obviously a crucial consideration in product selection. For many portfolio builders, ESG characteristics are assessed alongside other investment criteria that would guide the selection of any other kind of fund.
For example, does it provide the diversification one expects from the asset class? And for investors who are looking to replace a broad market fund with an ESG product in a portfolio, how well does it replicate the risk and return characteristics of the non-ESG benchmark? Answering these questions can help investors set expectations for the investment outcomes of a given ESG index fund.
ESG-screened indices will inevitably exclude certain securities which are included in their parent index. What precisely is removed, and how this is implemented, varies depending on the methodology and the screening approach used. These can range from exclusionary indices, which avoid or reduce exposure to certain business activities while seeking to achieve a market-like return, to “best-in-class” or “tilting” approaches, which include—or allocate more assets to—certain constituents according to a given ESG criterion.
Whatever the approach, investors should perform careful due diligence, otherwise the underlying holdings—and consequently the performance—of their chosen ESG index product may surprise them.
The largest constituents of an index naturally have an outsized role in driving its performance. For example, US ESG equity indices can in some cases have more than 33% of their market-weighted assets concentrated in their 10 largest holdings2, compared with around 23% for the broad US market3.
However, while different ESG benchmarks may on the surface seem to track a similar universe of stocks, some methodologies can omit certain unexpected stocks – in some instances, excluding the very biggest, household-name securities that can represent more than 5% of the parent index. Not only might these omissions surprise some investors – they can also have significant performance implications, especially for allocators seeking to use their ESG funds as core beta replacement.
Precisely why these names are excluded from some ESG indices and not others depends on a number of factors, such as the restrictiveness of the screening approach or the ESG ratings it is based on. As a result, even some of the largest constituents in the broad market can find themselves screened out of certain ESG indices. While many investors could well be comfortable with the rationale for exclusion, they should also consider the portfolio implications of exclusions such as the example outlined above.
Top 10 holdings of select US ESG equity indices relative to the broad US market
Source: Bloomberg, Factsheets. Data as of 31 December 2022.
Notes on abbreviations: for Sector (GICS): CD=consumer discretionary, CS=consumer staples, EN=energy, FI=financials, HC=healthcare, ID=industrials, IT=information & technology, ML=materials, RE=real estate, CM=communications, UT=utilities.
It’s important to have clarity around what any exclusions from an ESG index mean for the risk and return dynamics of the portfolio, and what this means for the performance of this ESG index relative to the broader market.
Excluding some of the biggest constituents of the broad market from ESG indices can alter the sector makeup of the ESG portfolio, which impacts its diversification properties. For example, screening out the largest tech names will result in a large IT underweight in the portfolio relative to the broad market, which must be redistributed between the other market sectors, affecting the index’s risk-return characteristics.
Investors should consider how a particular approach to ESG indexing can impact these variations in sector over- and underweights relative to the broader market. The more restrictive an ESG index’s methodology is, the further its sector distribution will stray from that of the non-ESG benchmark – and the more likely it is that its performance will deviate from the parent index.
A limited universe of securities relative to the broad market is one of the qualities most investors seek in ESG-screened indices. But just how pared-down an ESG index is dictates how far removed from beta it will be – and how much concentration risk it will expose investors to.
Taking a selection of European ESG equity indices as an example, the chart below contrasts the cumulative weight of their top 10 holdings, as well as those of the unscreened broad European market4.
Cumulative weight of top 10 holdings in select Europe ESG indices relative to the broad European market
Source: Bloomberg, Factsheets. Data as of 31 December 2022.
Notes on abbreviations: for Sector (GICS): CD=consumer discretionary, CS=consumer staples, EN=energy, FI=financials, HC=healthcare, ID=industrials, IT=information & technology, ML=materials, RE=real estate, CM=communications, UT=utilities.
Each coloured line represents the ten largest holdings of the different indices, with the figure next to the index's 10th-largest holding representing the proportion of the index’s assets that those top 10 holdings make up. For example, the broad European market4, shown by the amber line, holds all of the 10 largest stocks with no breaks in the line, to the tune of a combined 22.5% weight in the index.
As you might expect, indices that apply any kind of ESG exclusion are by necessity more concentrated than the broad market. And the wider the breaks in the line, the more skewed the percentage of the entire ESG index’s holdings becomes to its top constituents. As the chart illustrates, the concentration of the top 10 holdings of the ESG indices shown ranges from around a quarter (for the FTSE Developed Europe All Cap Choice Index) to more than one-third (for the MSCI Europe SRI Select Reduced Fossil Fuel Index and the MSCI Europe SRI Filtered Paris Aligned Benchmark Index) of the respective indices’ total holdings5.
Understanding this additional concentration risk as an index moves further away from core beta is crucial when it comes to taking a holistic, portfolio approach to assessing ESG indices. This is particularly the case for investors using these indices to take the place of broad beta funds in client portfolios.
With the universe of ESG indices expanding rapidly—and given the wide variation in the complexity and approach of the methodologies available—having transparency around how an ESG index is constructed and what this means for the underlying portfolio is crucial.
As a result, many investors are turning to exclusionary index products derived from common market-capitalisation-weighted indices to meet their ESG investing preferences. As well as helping to limit exposure to business activities that conflict with their ESG preferences, screened indices can offer a low-cost, ESG alternative to conventional index funds.
By offering broad exposure to a market or market segment, exclusionary ESG benchmarks can serve as building blocks for a broadly diversified portfolio. And because they can closely track the performance of the non-ESG “parent” benchmark—depending on the ESG index chosen—they can also serve as ESG-screened core beta replacement, for portfolio constructors who seek this.
1 Source: Morningstar Global Sustainable Fund Flows Report, as at 27 October 2022.
2 Source: Vanguard, as at 31 December 2022. The ten largest holdings of the MSCI USA SRI Select Reduced Fossil Fuel Index represented 33.04% of its assets as at 31 December 2022.
3 Source: Vanguard, as at 31 December 2022. Source: Vanguard, as at 31 December 2022. The ten largest holdings of the MSCI USA Index represented 22.96% of its assets as at 31 December 2022.
4 As represented by the MSCI Europe Index.
5 Source: Vanguard, as at 31 December 2022. The FTSE Developed Europe All Cap Choice Index had 24.99% of its holdings in its top 10 constituents, the MSCI Europe SRI Select Reduced Fossil Fuel Index had 35.98% of its holdings in its top 10 constituents and the MSCI Europe SRI Filtered Paris Aligned Benchmark Index had 37.19% of its holdings in its top 10 constituents as at 31 December 2022.
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