Indices that reflect investors' ESG concerns are proliferating and becoming more specialised, reports Nina Röhrbein

More and more products are being launched on the back of the attention paid to environmental, social and governance (ESG) issues by investors, the media and public. And one of the latest trends in this arena is indices.

"This year there has been a proliferation of ESG-themed indices, including JPMorgan's JENI-Carbon-Beta corporate bond index earlier in the year and more recently the HSBC Global Climate Change Index and the Merrill Lynch/Trucost Carbon Leaders Index," says Watson Wyatt investment consultant Jane Goodland. "Traditionally, investors have been limited to broader ESG indices such as the Dow Jones Sustainability Index or the FTSE4Good Index series. But now, more specialisation is occurring with focused indices, such as those related to climate change.

"There is more interest in tracking the performance of particular types of stocks, especially in the climate change solutions area, as investors allocate more capital to them. Pension funds can invest in this space via actively managed funds and indices can provide a reference point for such funds. They also create the opportunity for investors to run more passive funds against them, thereby creating a whole spectrum of investment opportunities," she adds.

The trend towards ESG indices is also demonstrated by the takeover of Impax Asset Management's Environmental Technology Index by global index provider FTSE Group and its re-branding as the FTSE ET50 Index.

"Institutional investors want to capture the performance of the companies they think will benefit from a changing, carbon-constraint economy and we wanted to provide something for that." says Will Oulton, head of responsible investment at FTSE. "That is why we teamed up with Impax. Our intention is to develop a series of indices next year as an extension of the ET50 - which comprises the 50 largest pure play environmental technology companies by market capitalisation worldwide - as ICB, the industry classification benchmark, has not really covered these particular sectors. We plan to look more specifically at some of the sectors within the index and see where we can create some other valuable indexes and benchmarks."

The interest by investors in ESG has been illustrated by the launch of several, particularly climate change related indices over the past four to six months by a range of players, according to Oulton.

Credit Suisse was one of them, launching a Global Warming Index this summer as part of a wide range of indices the bank has developed with its corporate performance and valuation advisory service HOLT.

"The Global Warming Index - covering companies dealing with four themes, namely demand management, renewable fuels, renewable electricity and emissions limitation - was our 11th index launch of the range, driven by rising demand for thematic indices," says Julia McAleenan, responsible for index products in Credit Suisse's European structuring team. "Our research department initially created the idea for this specific index after publishing a report on alternative energy and climate change."

Credit Suisse defines a regional or thematic universe for HOLT, which selects the most attractive stocks from the universe to go into the index. The Global Warming Index contains the five most attractive companies of each underlying theme in addition to the next 20 overall most attractive companies. The index comprises 40 companies subject to semi-annual rebalancing, according to McAleenan.

But McAleenan admits that the Global Warming Index, as it incorporates nuclear power, was not specifically set up as an ESG index. Instead, it was driven by popular themes and client feedback.

While many thematic indices, such as the Credit Suisse Global Warming Index, do not have an underlying benchmark, some like the JENI-Carbon Beta and the Austrian sustainability index VÖNIX are based on one. The VÖNIX, a collaboration of Austrian pension fund VBV and its subsidiary VINIS, is benchmarked against the Vienna Stock Exchange's ATX Prime benchmark and has outperformed it by 17% between its launch in June 2005 and September 2007.

The VÖNIX consists of 29 companies, selected from a universe of around 70 Austrian companies, subject to an annual review. It started off with 21 Austrian equities but added six mainly small and mid-cap stocks following a 2006 review. In 2007, four additional stocks were added, while two were excluded according to ESPA VINIS' ESG criteria, says Martin Cech, fixed income portfolio manager at VINIS.

"VBV started its SRI policy in 2003 with the launch of a global SRI equity fund that is measured against normal broad market benchmarks such as the MSCI World. Despite the existence of SRI benchmarks and indices, we noticed that mandates across the pensions fund market normally use a conventional broad market benchmark as their main benchmark. The VÖNIX was the result of the desire to have an index that focuses on SRI in Austria," says Cech.

The index, he says, faces no competition, with the only other SRI index in Austria, by financial services provider ÖKB, comprising Austria-listed equity funds rather than single stocks.

Standard & Poor's (S&P) Index Services has already launched six thematic indices this year - covering clean, nuclear and alternative energy as well as water, timberland forestry and infrastructure - that contain around 20-50 stocks each.

"A number of ETFs trade on our thematic indices, while institutional asset managers have also successfully created structured products based on them," says Alka Banerjee, vice president of global index management at S&P. "These indices are more useful as a basis for derivative products than as benchmarks, since benchmarks need to be broader. However, it is more difficult to find enough companies with a focus on very specific themes for a broader index. To create a broader index you have to go into a wider ESG arena, and this is something we are doing with the pilot ESG emerging market indices for India, which S&P is developing as part of a consortium alongside our Indian subsidiary CRISIL and US-based KLD Research & Analytics."

S&P has developed a methodology to score companies on ESG for the two India indices - a broader one with 100 stocks and a narrower one with 50 stocks set to launch in January 2008. This methodology scrutinises the companies' own disclosure and transparency, their public statements as well as publicly available documents and news stories about their performance in these areas, upon which a score will be calculated and the highest ranking ones will be included in the indices, explains Banerjee.

"Depending on the response to the India indices, we may also expand into other emerging markets. We expect a lot of demand for the new indices, as Indian companies with lower ESG standards will at some point be penalised by the market. And the demand, we believe, is here to stay. While current interest largely stems from Europe, the US is slowly waking up to it too," says Banerjee.

These new thematic indices follow in the footsteps of the FTSE4Good. That series of nine benchmark and tradable indices, aimed at socially responsible investors and containing companies that meet internationally accepted standards and norms of corporate responsibility, was launched ahead of its time in 2001, says Oulton.

"With its launch, FTSE4Good started a high-profile debate about SRI in the UK and Europe. Since then its individual indices have been developed and incorporated tighter environmental, human rights, anti- bribery and corruption, supply chain labour and climate change criteria," says Oulton.

But Goodland is cautious about making comparisons between ESG indices. "Sustainability indices are very much a product of their research input and construction process, so comparing indices with different methodologies is difficult," she says.

"Often investment bank proprietary indices are not as transparent as the ones from an independent index provider because it is part of the value they are selling," says Oulton. "But if there is enough investor demand - and I don't see the interest waning in the short to medium term - then they will be successful. We do not compete with each other as some clients want independent benchmarks, while others are happy with the proprietary ones provided by intermediaries so there really is a market for all."

"What really matters is how transparent the methodology for each index is and what exactly it brings to the client," says Banerjee.

The future success of these indices, according to Goodland, depends on how they are used in practice.

"There is a lot of discussion about whether clean-tech companies are overvalued so indices can be a useful tool to track these stocks. But as many of these indices are relatively new, we will have to wait and see how well they are received," Goodland adds.

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