The effects of adjusting equity indices to exclude worst-ranked stocks based on sustainability-related criteria varies depending on the type and objectives of the screening approach chosen as well as on how we reweight the screened stocks.
The impact on the performance of equity indices when using sustainability-related criteria to exclude the stocks with the poorest ranking depends on the goals of the screening, how the stocks screened are reweighted, and the period, the scope and the measurement method chosen.
In this study, we examined the impact of four approaches we commonly use on the performance of four broad large-cap equity indices:
- BNPP AM’s Responsible Business Conduct (RBC) policy – with the objective of mitigating risk, this excludes companies from investment that we consider in breach of international norms and guidelines or with significant exposure to sensitive sectors
- Environmental, social and governance (ESG) selectivity – with the objective of enhancing risk adjusted outcomes, this is a company scoring approach which aims at assessing each company against its sector peers and is based on sector specific material factors. It can be used to exclude worst ranked stocks.
- Sustainable Investment (SI) basket – with the objective of identifying stocks that meet the sustainability-related criteria required by the Sustainable Finance Disclosure Regulation (SFDR), can be used to screen stocks that fulfil the criteria and exclude all others
- Exclusions from three sustainable fund labels: Towards Sustainability (TS), Investissement Socialement Responsible (ISR), and the Paris Aligned Benchmark (PAB) – with the objective of defining a set of minimum sustainability-related criteria with specific exclusions and additional requirements that apply to all eligible funds, each label facilitates the comparison of performance and risk of funds with the same label.
We used two methods to reweight the indices after the applying the exclusions:
- Rebasing the index while setting stock weights proportional to the market capitalisation of the companies
- Finding the allocation to screened stocks that is more likely to reduce the impact of exclusions on the index performance.
The first method is simple, but can introduce unwanted sector and style biases, while the second method is more robust, but requires the use of portfolio optimisation techniques.
Key findings
For rebased indices: Reweighting using market-cap weights resulted in larger return differentials and more volatile differences between the returns of the reweighted index and returns of the original index
For optimised indices: Constructing portfolios cleverly using optimisation led to smaller return differentials and less volatile differences in returns thanks to smaller sector allocations and style exposure differences.
Based on the simulation of performance of the reweighted indices over the last five years, we found that:
- The RBC policy had a small negative impact over full period, but the effect on short-term performance can be larger, with the largest negative impact in emerging markets. 2022 was the most difficult year mainly due to the underweight position in the energy sector
- Applying ESG selectivity resulted in positive performance versus the original global, US and emerging market indices, but there were some difficult years such as a poor 2022 mainly due to the energy sector underweight
- Constructinga sustainable investment basket by screening for SI-grade companies led to positive performance across indices over the full period, resulting in the smallest number of stocks in each reweighted index and the largest volatility of the differences of returns relative to the original index. 2022 was difficult for the global, Europe and emerging market reweighted indices. Systematically constructing SI-grade only indices had a notably positive effect in particular for emerging markets
- The sustainable fund labels exclusions had a comparable impact leading to an overall positive contribution to performance, but with some difficult years. A poor 2022 was – again – mainly due to the energy sector underweight.
Sustainability metrics: All reweighted indices had higher ESG and lower carbon intensity scores than their respective original market capitalisation-weighted indices.
Even the less stringent RBC policy generated significant increases in ESG scores and reductions in carbon intensity.
Reweighted indices significantly reduced the exposure to revenues misaligned with Sustainable Development Goals (SDGs) and increased exposure to revenues aligned with SDGs. The SI basket had the largest reduction in misaligned revenues and the largest increase in aligned revenues.
Limitations
The analysis is based on the most recent five years only and relies on simulated index performance which may not fully capture longer-term impacts or future market conditions. Transaction costs, market impact, liquidity constraints, and real portfolio constraints were not included in our analysis.
Moreover, the results may differ if these screens are applied to smaller capitalisation stock indices or to country indices where exclusions can have a much bigger impact.
We advise against generalising these results to include actively managed funds based on fundamental analysis because extra-financial considerations are often embedded in a decision-making process along with other considerations, liquidity constraints or real additional portfolio constraints of active funds. Those were not considered, and the combined effect of overlaying multiple sustainable criteria was also not investigated.
Nevertheless, despite all these limitations, we believe the insights from this study can help investors understand the potential benefits – and risks – associated with incorporating sustainability in commonly used equity market indices.
