Incorporating ESG into US equity benchmarks

Investors wanting to incorporate ESG considerations into a broad US market passive portfolio have traditionally had to accept a certain – often high – level of deviation from the risk/return characteristics of their benchmark.

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Carolyn Eagle is Senior Product Manager, Sustainable Investment at FTSE Russell

Interest in ESG at all time high 

More institutional investors are considering ESG than ever before. Our 2021 survey found that 84% asset owners globally are evaluating and implementing sustainable investment (SI) considerations in their investment strategies, up from 53% in 20181. 

In North America the survey showed it is quickly catching up with EMEA. 68% of asset owners surveyed said they were either implementing or considering ESG, increasing from 39% in the last three years. 

Are fund flows matching the levels of interest?  

In short, yes, the growth in interest is translating to growth in assets in the US. This year, up to $550 billion of assets under management (AUM) are in ESG or socially responsible investment (SRI) funds – an 88% increase since 20182. With the Refinitiv Lipper team we looked at what kinds of ESG strategies in the US market are attracting increasing levels of investment. 

Fund flow data, according to Lipper, indicates that most of the sustainable fund flows are into passive equity strategies. Since the start of 2020, passive ESG/SRI funds saw ~70% of total inflows, while only accounting for ~25% of total AUM in ESG/SRI funds3. 

While active ESG equity estimated net flows are hovering around zero, ESG passive equity AUM estimate net flows are positive. 

What is an ESG equivalent of a flagship benchmark? 

With the interest for a broad US market portfolio with different levels of ESG in mind, we designed the Russell US ESG Indexes. The suite of six indexes is a broad-based, alternatively-weighted, US equity index family designed to measure the performance of mega-cap to micro-cap securities that meet improved index-level ESG profile, while maintaining similar risk/return characteristics to the underlying universe.  

There are two sub-index families available, with different levels of exposure to ESG: 

Russell ESG Screened Target Exposure indexes 

This sub-family of indexes applies a negative screening approach, by excluding companies based on certain business operations or product involvement. Companies are also excluded that potentially breach the United Nations Global Compact principles.  

Russell ESG Enhanced Target Exposure indexes 

This sub-family of indexes applies the same negative screening approach as the ‘ESG Screened’ indexes. In addition they apply Refinitiv ESG Scores as a tilt to provide an ESG lens on the US equity universe. 

By applying the Refinitiv ESG scores into FTSE Russell’s Target Exposure index methodology we can produce an index with a 10% ESG score improvement that is still investable and performs similarly to the benchmark. 

What is FTSE Russell's Target Exposure approach? 

FTSE Russell's target exposure approach provides a transparent mechanism for exercising precise control over ESG objectives. 

For these indexes the approach neutralises active industry exposure while also controlling tracking error and beta. This, combined with industry active weight changes, should offer investors the confidence that the ESG indexes can serve as a suitable alternative to the underlying benchmark. 

Index performance

While it is important not to confuse correlation for causation, we do find in practice some evidence of risk-adjusted outperformance of ESG indexes against their parent benchmarks. Over the period from December 2016 through November 2021, the Russell 1000 ESG Enhanced Target Exposure Index outperformed the underlying benchmark's annualized gain of 18.84% by 100 basis points, with comparable volatility. The tracking error over this period remained at 1.02%. 

An alternatively weighted index can be seen as suitable replacements for the traditional benchmark, further driving assets into the strategies. It can serve as a gateway or steppingstone for a new ESG investor.  

Russell 1000 ESG Enhanced Target Exposure Index vs Russell 10004

1 FTSE Russell, Sustainable Investment: 2021 global survey findings from asset owners
2 Refinitiv Lipper, July 2021. Includes both active and previously liquidated funds (ETFs and mutual funds)
3 Refinitiv Lipper, July 2021. Past performance is no guarantee of future results
4 FTSE Russell, based on monthly data from December 31, 2016 to October 31, 2021