The S&P 500 index, one of the most recognizable stock indices in the world, just got a makeover in line with the latest trend in finance: ESG, or environmental, social, and governance, investing.
The S&P 500 has been around for more than 60 years and features the largest companies publicly trading in the US. Its sheer size and market dominance means lots of money flows around it. The index underlies the oldest and largest exchange-traded fund (ETF) listed in the US, the State Street SPDR S&P 500 ETF. This fund is designed to replicate (before fees and expenses) the return of the US benchmark index and has more than $262 billion in net assets. In fact, the three largest ETFs all aim to track the S&P 500 and together have about $575 billion in assets, according to data from JP Morgan.
These days, more and more investors are looking for ways to align their money with their values, which has led to a growth in ETFs that aim to do everything from supporting gender equality to mitigating climate change. In the past year, about 30 ESG-themed funds were launched globally and the size of the ESG ETF market grew by more than 40% to $32 billion, the JP Morgan report showed. These ETFs need indexes to run off of.
Last month, S&P Dow Jones Indices launched the S&P 500 ESG Index. This new index takes the benchmark 500 index and excludes companies that don’t meet certain ESG criteria. The goal of the ESG index is to closely replicate the risks and returns of the S&P 500. Reid Steadman, the global head of ESG indices at S&P Global, said this index should help create a new era of ESG investing.
It would be an era in which ESG investing is more mainstream and accessible. Previous ESG-themed indexes by S&P were built “to reflect strategies where the goal was to have a return that differentiated from the market,” Steadman said in an interview at S&P’s London office. “That is appropriate for someone who is willing to take on those risks and is of super high conviction that they can use those indices to achieve a certain return.” The S&P 500 ESG index isn’t trying to offer that. It’s about getting market return but with the “social alpha” of just investing in companies at the top end of sustainability and governance metrics. The ESG index has a less than 1% tracking error to the S&P 500. With more than half a trillion dollars chasing the market returns of the S&P 500 index, why not switch to the ESG version?
Maybe the ESG index seems almost too good to be true—an S&P 500 index that could be turned into a fund (and has been by UBS Asset Management), but only with the “best” companies.
The problem, as with many indices and funds in the ESG investing world, is who decides what’s good and what’s bad. There’s a lot of fragmentation in the ESG market. S&P works with RobecoSAM, a Swiss investment firm specializing in sustainability, to give companies ESG scores. But there are other companies that do the same thing, including Sustainalytics, while some banks prefer to do it in house. This means one company can end up with very different ESG scores (paywall) depending on who is doing the grading. Not all efforts to create standardization are popular either. The European Union is working on a classification system for what counts as environmentally sustainable investments, but this has divided opinions in the industry.
The S&P 500 ESG index has in some ways a light touch of deciding what fits the definition of ESG investing. Steadman calls the index a “starting point” for ESG investors. Companies are excluded if they produce or sell tobacco, or if they have more than a 25% stake in a tobacco company. Companies are also excluded if they are involved in “controversial weapons.” But a decision to create different classes of weapons is controversial in itself. For the sake of the S&P index, controversial weapons are cluster weapons, landmines, biological or chemical weapons, uranium, or nuclear weapons. Selling firearms, for example, doesn’t warrant an exclusion. Then companies with a low score for the UN Global Compact, a set of 10 principles on human rights, the environment, and anti-corruption that companies sign up to, are cut out from the ESG index. However, this only excludes two companies. And finally, companies that score in the bottom 25% for their industry group using the S&P ESG scores are also excluded. In the end that leaves 316 companies (pdf) in the S&P 500 ESG index.
Some of the larger companies in the S&P 500 index to be excluded from the ESG index are:
- Boeing for its involvement in nuclear weapons
- Berkshire Hathaway and Netflix for scoring too low on the UN Global Compact (The UN website suggests they aren’t participants)
- Alphabet for having an S&P ESG score that was too low
- Johnson & Johnson, the third (after Berkshire Hathaway and Alphabet) company in the top 10 of the S&P 500 index to be excluded from the ESG index, also for scoring too low.
The S&P 500 ESG isn’t expected to topple the benchmark index any time soon. But Steadman said there could be a natural convergence between them. As ESG values become increasingly important, companies that adhere to them should get larger and push out companies that don’t. If ESG investing truly becomes mainstream there would be little difference between the ESG index and the main index. S&P plans to introduce more country and regional ESG indices in the coming months. Already the interest in ESG from investors is feeding back into company practices as more firms are publishing the non-financial information needed for ESG scores. Last year, 86% of the companies in the S&P 500 published sustainability reports.
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