Picture: ISTOCK
Picture: ISTOCK

There has been a growing perception in recent times that index investors cannot apply responsible investment principles to their portfolio holdings. This thinking is based on a fundamentally flawed argument.

On the contrary, given that an index fund does not have the option of selling out of a stock, index investors have even more incentive to ensure that the stocks they are mandated to hold continue to offer sustainable returns through the consideration of environmental, social and governance (ESG) factors.

Traditional indices historically had limited scope to incorporate ESG factors, which resulted in exposure to companies with controversies or poor ESG ratings.

However, innovation in index investing in recent years has broadened the capabilities of index-tracking investment managers in this respect, allowing them to incorporate ESG factors in their investment process. The market is now experiencing an increase in low-cost indices that offer ESG-led mandates and champion responsible investment.

Strengthen practice

A 2015 research paper by Elroy Dimson of the University of Cambridge and London Business School, Oguzhan Karakas of Boston College and Xi Li of Temple University shows that successful active engagement can and does add alpha over time. For index fund managers, who are generally assumed to be passive investors and who are mandatory holders of assets over time, the incentive is clearly to identify the weak players in their portfolios and work with them to strengthen their practice.

As such, engaging in active proxy voting is a critical means of influencing the business practice of companies within a tracker portfolio.

Index managers who don’t do this are not serving the best interests of their clients.

Meaningful exposure

The client outcome of this approach is that for a relatively small amount of "active risk", market-like returns can be achieved by holding a basket of companies that are measurably better when considered on an ESG basis. This is organic at a cheaper price.

To illustrate this point, we have taken the following steps to create an index that offers investors a benchmark that has meaningful exposure to ESG factors — the first of its kind in SA.

Morgan Stanley Capital International (MSCI), a leading index provider, collected ESG-related data through its in-house research capability.

The trend shown supports the fact that the ESG-led index has paid off relative to the market index

Through a proprietary weighting methodology we built an index with this data that has exposure to the most sustainable companies in SA.

While the index itself does not have absolute ESG screens, the index construction process is based on peer-relative ESG performance.

Chart 1 illustrates the performance of this index, the Old Mutual responsible investment equity index, in relation to the JSE shareholder weighted index. Though we cannot guarantee future outperformance, the trend shown supports the fact that the ESG-led index has paid off relative to the market index. The table illustrates how the excess return depicted in the chart was also achieved at a lower volatility than the JSE shareholder weighted index.

Strong demand

More than 1,200 asset owners, investment managers and professional service partners have become signatories of the UN-backed principles for responsible investment.

Broad acceptance of these practices in the market has translated into strong demand for investment products that are sustainability themed. As at December 2017, MSCI reported that about $98bn of assets was benchmarked against the MSCI ESG indices.

ESG-led index-tracking products can offer investors the opportunity to send signals to capital markets that sustainability considerations are of prime importance, without adversely affecting the risk-return characteristics of an investor’s financial returns while also benefiting from substantially lower fees.

ESG indices empower investors to vote with their feet by investing only in companies with high sustainability profiles, without compromising on investment returns.

• Sibiya is index portfolio manager and Duncan head of responsible investment at Old Mutual Investment Group.