Building Sustainability Indexes

Building sustainability indexes is a specialist function for index architects. The Domini 400 Social Index has been running since 1 May 1990 as a benchmark for the obvious question: including ESG factors in selecting large US companies, how does it impact performance. The ETF tracks at iShares FTSE KLD 400 Social Idx Fd (ETF) (Public, NYSE:DSI). Over the years the DS400 has come to send many other messages, and practitioners know the strengths and weaknesses of this specific index, but it has established the role for the sustainability index. The purpose of an index must be clear in order to create focus for any sustainable investment approach. At SinCo we recommend that any index must be succinctly defined. Sharpening the sustainable investment focus is critical. Criteria matter. So does longevity. Many interesting variations will emerge in the design, development and ongoing execution of the index, and tensions within the mission and current programs may be expected. Maintaining focus prevails on the choice of work and work partners and the design of selection criteria. The Dow Jones Sustainability Index is now 10 years old [see the latest review with DJ here] and some of the people who helped build it like Alex Barkawi have moved on.

Our experience of sustainability indexes provides the empirical basis for design directions and development, interpreted by experts in sustainable investment and the role of indexes. The emergence of country-level indexes rather than international (for example DJSI Global) or themes indexes (for example, carbon or water). South Africa is an obvious example in emerging markets with the JSE SRI Index [up this year, together with Brazil (BOVESPA ISE) launched by the IFC in 2005, and India (S&P CRISIL/KLD/IFC), as well as emerging country examples in Egypt, Spain and South Korea, together with newer thematic indexes such as the Healthy Living Index (SAM) and international initiatives like the Carbon Leaders Index – CDLI (CDP/Innovest).

• SAM Sustainable Healthy Living Fund is designed to invest from the global stock universe in the most attractive enterprises along the health value added chain. For this purpose those trends which influence the Healthy Living-sector decisively are investigated in the first step by means of macroeconomic analysis.
• Carbon Leaders Index – CDLI (CDP/Innovest) The CDLI scores for the Global 500, Europe, FTSE 350, and S&P 500 companies are now used by index provider Markit to create a family of equity indices.
  

Index architecture must map to the investment case and the index proposition. We will cover the impact of sustainability indices separately, other than to say now that sustainable investment indexes have an impact, but a complex model is needed to assess the impact. Indexes (and indexed portfolios) are actively managed investment instruments that are constructed according to objective criteria and are compiled and marketed by financial services firms such as FTSE Group/Financial Times [www.ftse.com/Indices], Morgan Stanley Capital International Indexes [www.msci.com], Standard & Poor’s Indexes [www.sandp.com] and Dow Jones Indexes [http://www.djindexes.com/].

Index membership literally confers “investment grade” on firms because numerous managed funds are benchmarked to, or directly invested in, these indexes. Where the index is themed, selection into the “club” confers a certain halo effect or positive association for that company because there has been a dramatic increase in the scale of funds that directly track market indexes. Gaining and maintaining membership in an “index club” is often a critically important goal for company executives. As with any differentiating characteristic, companies seek to gain competitive advantage with investors, prospective employees, and other stakeholders, and a high ranking in an index can give them such an advantage.

When a company is ranked or included in an influential or prestigious index such as the Dow Jones Sustainability Index (DJSI) or the Fortune 100 Best Companies to Work For, the company will reference that fact, especially when that firm is looking to present credentials as being “world-class”. For example, Brazil petroleum major Petrobras [Petroleo Brasileiro SA (ADR) (Public, NYSE:PBR)] lists five accreditations on a full-page color advertisement in a magazine targeted at investors and company executives (Bloomberg Markets magazine, December 2009), including membership in the DJSI. On the other hand, exclusion from an index can encourage companies to pledge changes. When Daimler [Daimler AG (Public, ETR:DAI] and Bayer [Bayer AG (Public, ETR:BAYN)] were excluded from the DJSI STOXX, their reaction in the German business paper Handelsblatt on 8 September 2008 ranged from pledges to improve (“We will definitely intensify our efforts regarding sustainability”, according to a spokeswoman from Daimler AG) to surprise at being excluded (Bayer commented, “We are not happy about it and we will try our best to be included again, since this is increasingly relevant to us on a financial basis. However, it will be more and more difficult to achieve inclusion in this benchmark.”). Our experience is that ratings, rankings and indexes may be a powerful tool for driving forward sustainability and creates a signaling effect across sectors and stakeholders. At this time we do not delve into the detail of ratings, rankings and indexes. There exist many different approaches, and characteristics of each of the three may be quite different, offering different value propositions that the index leadership must address at the outset of their goal and objective setting stages. Indexes are a feature of any discussion, a reference point, and quite literally a benchmark. Sustainability indexes can be even more so.