Although the magnitude of the outperformance varies among the different ESG index providers, it’s important to note that each has beaten the benchmark over time and has done so consistently, regardless of ESG methodology or ESG data provider. And while past performance is not an indicator of future results, we believe that the performance demonstrated by US ESG Indices since their inception is worthy of consideration.
Drivers of ESG Outperformance
So what are the drivers of the year-to-date outperformance of the four US ESG indices, and are they the same across the different permutations of ESG index strategies? To understand performance drivers over the first half of 2020, we decomposed active returns and identified three common themes.
We performed a sector attribution for the ESG indices relative to the S&P 500 Index, for one year as of June 30, 2020. For all four of the indices, Information Technology was the sector that contributed most to outperformance. Depending on the specific index construction approach, Industrials, Financials and Consumer Discretionary all contributed to outperformance. Interestingly, the Energy sector underweight that is a common theme in ESG index strategies was not found to be a large driver of added value.
All four indices also show modest active style factor exposure relative to the S&P 500. We see positive exposure to momentum (given the strong performance these indices exhibited) and profitability (usually associated with high-quality stocks). At the same time, we see negative exposure to value and leverage (again associated with high-quality stocks). Given the limited history of robust ESG data (versus traditional style factor premia), we didn’t expect to see a consistent relationship between the ESG profile and any one particular style factor. Rather, sources of active risk and return may be attributable to idiosyncratic features of a provider’s ESG signal.
We examined the ESG index exposure and attribution through the lens of State Street’s R-Factor™ an innovative, transparent ESG scoring mechanism that measures the performance of a company’s business operations and governance as it relates to financially material ESG issues facing that company’s industries. R-Factor™ facilitates an objective analysis of the ESG tilts embedded in each of these indices. Note, however, that while we believe that companies with higher R-Factor scores are generally managing their ESG risks better, and that the proactive management of ESG risks is a marker of company performance, this of course does not always result in better stock performance.
All indices demonstrate an improved ESG profile vis-à-vis the S&P 500 index, as measured by R-Factor™. In addition to incorporating an ESG tilt, index construction plays an important role in holdings and therefore performance. For example, the MSCI USA ESG Universal Index presents a very low R-Factor™ improvement over the S&P 500 Index, but this is likely due to the index methodology that prioritizes diversification through a large number of securities with only a minimal ESG tilt. Investors looking for indices that provide higher exposure to ESG should note these key construction differences.
And, while all indices reported a positive overweight to R-Factor™, the highest scoring ESG stocks (i.e., first quintile) made by far the largest contributions to active returns, resulting in a positive allocation effect all ESG indices. See Figure 4. This reinforces our perspective that an improved ESG profile was a likely source of value add over the past year.