Index Committee Or Index Rules?

April 26, 2012

However, sustainable investing is often dominated by a focus on negative publicity such as that resulting from major disasters like the Deepwater Horizon oil spill and the Fukushima nuclear accident, which affected companies like BP, Transocean and Tepco. While in such incidents companies found liable would certainly score 0% on a pollution criterion, an ESG model could still return high overall scores under a strict rules-based application, since the model does not account for the level of severity of a potential breach.

Here, an individual research analyst might employ common sense to adjust models for individual stocks, based on investor perception. But as in the previous discussion of index committees, this would represent a significant active intervention into a passive investment approach. By making such a judgement, the analyst and the index concept based on it would assume that all investors share the opinion that the specific criterion is to be overweighted given the circumstances.

The rules-based concept makes amends for this issue by introducing fast-exit criterion, leading to exclusion of companies that show significant breaches of the UN Global Compact criteria, as set forth by the United Nations. This is a good example of how the governing rules for such rules-based indices can be adjusted to deal with potential issues in the index construction methodology. However, at the first occurrence of unexpected news, a committee- or research-driven approach has the advantage of increased flexibility.

Another core argument for the traditional approach is that the research provider with analytical capacity is simply in a better position than an individual investor to evaluate the sustainability of a company. The investor is thus able to "outsource" the definition of sustainability to a reputable third party and go along with that party's values and definitions. An added benefit of this is that the asset manager can outsource stock selection to the independent research house.

However, today we notice an increasing demand from investors who are willing to take an active responsibility for the sustainability of their investments and want to combine this with their own core values. This can easily be observed by tracking the number of firms that have signed up for, as well as the assets managed in accordance with, the United Nations Principles of Responsible Investing (UNPRI). The growth has been exponential in recent years. It is this group of highly educated and sophisticated investors in sustainability, who have their own views and a clear understanding of the definition of a sustainable company, who can make the most use of a rules-based approach. Of course, many of those investors' opinions on the valuation and relative weightings of the individual KPIs will differ, just as individual definitions of sustainability differ. The advantage of a rules-based selection approach is that the rules can easily be customised and, in contrast to a proprietary research approach, any differences in valuation are clearly visible.

To sum up, we believe it is fair to say that while the value added by an index committee's selection of stocks or index components can be found in the areas of continuity and diversification, the committee approach does add a significant active component to the index. This contradicts the passive nature of the index and adds an element of unpredictability and, ultimately, risk to the indexing equation. Depending on the investor's expertise, this active intervention by the index committee or research provider may add more or less value.


Find your next ETF

Reset All