Challenging Global Index Giants with ESG Precision

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Stockholm (NordSIP) – While the world of ESG-index strategy providers might be dominated by giants such as MSCI, FTSE Russel or S&P Dow Jones Indices, smaller players may bring an interesting angle in defining ESG parameters more precisely. We caught up with Dr Axel Hesse, founder of SD-M® GmbH, to discuss his work, performed over the last 19 years, diligently developing his method.

SD-M is an investment advisor specialising in the integration of relevant ESG factors in the investment process, based in Germany. The advisory services are supported by two products: the identification of the three industry-specific key performance indicators (SD-KPIs), and SD-KPInform®, a database that evaluates SD-KPIs for more than 5000 companies worldwide. “SD-M is the global pioneer for standardized ESG integration”, says Dr Hesse.

“I began working under the SD-M logo in 2001. The development of the SD-KPI standards began in 2003 and we were fortunate to enjoy the support of the German Environment Ministry (BMU), the Sustainability Accounting Standards Board (SASB), accountants as well as global investors and analysts”, says Dr Hesse. “The first SD-KPI Standard was published in 2010, with the participation of Ethix and GES, among others. The next milestone was the launch of the iSTOXX SD-KPIndex® family in 2013, before the publication of the updated SD-KPI Standard in 2016.”

SD-M cooperated with the index provider STOXX to develop a series of SD-KPI products. The collaboration was motivated by the realisation that the market was not satisfying the needs of socially responsible investors (SRIs). “SRI niche indices, like the Dow Jones Sustainability Indices or the FTSE4Good Index Series, often do not meet the needs of institutional investors who would like to incorporate environmental, social and governance (ESG) issues into their investment process, which includes mainstream indices and benchmarks,” clarifies Dr Hesse in a report.

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According to the founder, “SRI niche indices differ too much from mainstream indices. Exclusions and best-in-class lead to large reductions in the investment universe in SRI niche indices, the number of index components is radically reduced through exclusions and/or best-in-class strategies. For example, in the Dow Jones Sustainability World Index only about 333 components are selected in a ‘best-in-class’ approach from the mainstream S&P Global Broad Market Index, which consists of 2500 components. This means a reduction in the investment universe of about 86,7%.”

The iSTOXX SD-KPIndex family currently consists of EURO iSTOXX 50 SD-KPI, iSTOXX Europe 50 SD-KPI and iSTOXX Europe 600 SD-KPI. “The methodology entails an incremental change approach with a small tracking error and liquid derivatives available. For example, in the iSTOXX Europe 600 SD-KPI all 600 components of the parent index STOXX Europe 600 are included but are over- and under-weighted according to Sustainable Development Key Performance Indicators (SD-KPIs). This reduces the large-cap bias associated with mainstream indices and other ESG indices”, clarifies Dr Hesse.

SD-M points to a number of attractive features of its product. The SD-KPI evaluation is more accurate, Hesse says. “Take the case of BP. Before the Deepwater Horizon explosion on 20 April 2010, BP was often best-in-class in broad sustainability ratings, but not in a focused SD-KPI evaluation. The three SD-KPIs for the oil and gas industry were published in January 2010. The result was an accumulated SD-KPIntegration Score of 32.85, meaning that in the iSTOXX Europe 600 SD-KPI Index, BP’s weight was 25% lower than in the STOXX Europe 600,” he adds. SD-M’s more accurate assessment is also linked to potentially higher long-term returns. The iSTOXX EUROPE 600 SD-KPI index seems to outperform the benchmark STOXX Europe 600 Index over a five-year long term investment horizon. While the same cannot be said of the short-term, the long-term gains are achieved without any increased volatility.

“The next step is thus to launch ETFs and index funds based on the iSTOXX SD-KPIndex family. This is planned for 2019 and we expect it to be made available to smaller institutional investors and retails clients,” says Dr Hesse. “We believe that ESG integration is the future for mainstreaming responsible investments for all conventional investment processes, active, quant and passive,” he concludes.

Picture © NordSIP

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