The risk of being ‘good’:
Integrating Responsible Investing and Enhanced Indexing

February 2020

Here’s the dilemma: Index Investing exposes investors to the entire Index, warts and all, while any deviation puts investors on the path to active management. Therefore, incorporating Responsible Investing cannot be passive, it is an active investment decision and, in most cases, implicitly assumes that ‘good’ ESG companies are also ‘good’ investments. This in turn creates a risk that the resulting Responsible Investment portfolio does not deliver the risk nor the Index return. Some investors can live with this, while others, who want a passive investment to the Index whilst doing ‘good’, can’t.

If your aim is to replicate the Index by only investing in ‘good’ ESG companies, as a ‘passive investor’ you take on that Tracking Error risk. This may seem trivial or a small ‘price to pay’, but ‘bad’ ESG companies have delivered significant historical outperformance. In the meantime, thematic solutions around climate change and ESG have also performed very strongly since the global financial crises.

The continuation of this outperformance could be challenged by investors recognising the true risks of ‘bad’ ESG practices, steering capital – both equity and debt – towards a Responsible Investing agenda. Also, we see a dramatic change in behaviour of the consumers, as they want products and services that are environmentally sustainable, so companies are changing. In addition, our own Central Bank, the Bank of England, has explicitly made the link between the impact of economic activities on the environment and the impact that the environment can affect the global economy.

Evidence shows that outperformance of ‘bad’ ESG companies can be explained by a combination of factor exposures and the requirement for ‘bad’ ESG companies to deliver a higher return given the higher risk tolerance needed to invest in these companies. Companies with high ESG scores exhibit positive exposure to the low volatility and quality factors and negative exposure to the value and size factors. Therefore, by excluding ‘bad’ ESG companies the portfolio is short potentially attractive factors and is demonstrably different from the Index by not only having different country and sector exposures, but also factor exposures, which can result in a sizable tracking error. The remedy to this unintended factor, country and sector exposure may be restored by investing in companies with offsetting exposures.

The good news is that a Responsible Investment portfolio can achieve the risk and return of the Index; but investors must accept that this is not a passive investment. Once this point has settled, the next step to replicate the Index with a Responsible Investment portfolio is to determine the best way to utilise the Tracking Error that has been generated.

First, let’s define what could be considered a Responsible Investment portfolio.
According to Nordea’s Multi Assets Team, a strong Responsible Investment portfolio should have an ESG average rating of at least A, and exclude companies that:

  • Are involved in the production or maintenance of illegal or nuclear weapons, including cluster munitions and anti-personnel mines,
  • Are within group-wide sectors such as tobacco and gambling,
  • Are listed in the “CU200”, which is a list produced by the research provider “Fossil Free Indexes”,
  • Have more than five percent of revenues from fossil fuels, and finally
  • Have a rating below BB MSCI ESG.

The remaining universe after these exclusions is about 1800 companies in MSCI All Country World Index (ACWI). In other words, about 1000 companies, out of 2850, have been excluded. This may seem excessive… but, in our view, incorporating ESG scores is only one part of being a Responsible Investor.

The universe should now only contain ‘good’ companies, but as mentioned earlier, ‘good’ companies are not necessarily ‘good’ and outperforming investments, as this Responsible Investment Universe makes no explicit alpha assumptions about the ‘good’ companies, or even about the companies excluded. The removal of ‘bad’ companies can create long-term value by reducing risk, but this simply concerns risk management. So, how can we select ‘good’ investments from a ‘good’ universe to deliver the Index risk and also its return?

At Nordea we believe this can be achieved through Enhanced Indexing.
As an example, our Sustainable Beta+ Strategy aims to deliver the risk and performance of the MSCI All Country World Index¹ . The companies exclusion criteria are exactly as outlined above. Through our Enhanced Indexing approach, which we call Beta+, the aim is to achieve alpha by utilising a low level of Tracking Error. It’s this alpha that allows us to be confident that we can deliver the Index return; it also helps cover the costs of managing the portfolio and thus achieves the index return after transaction costs and fees. Unlike passive investing.

How does our Enhanced Index approach determine ‘good’ investments within a ‘good’ universe
Firstly, it’s important to highlight that the strategy aims to generate most of the excess return from company selection. Beta+ uses both risk premia and a proprietary company selection methodology that has proven to be indicative of future excess return. We also filter out from this ‘good’ universe companies that are expensive, low quality and have deteriorating earnings or cash flows. These could be called the ‘uglies’ and our evidence shows that we can generate alpha from avoiding these ‘ugly’ companies.

Putting it all together: the Nordea Sustainable Beta+ Strategy incorporates a comprehensive Responsible Investment screening to identify ‘good’ companies, we then apply our Beta+ process to select ‘good’ investments within the ‘good’ companies. Meanwhile, we keep sector and region risk tightly controlled to deliver the MSCI All Country World Index return, net-of-fees.

In conclusion, it is possible for a Responsible Investor to track the Index risk while also matching the Index return.

¹There can be no warranty that an investment objective, targeted returns and results of an investment structure is achieved.

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