Sustainable index investing is rapidly gaining in popularity, which raises two important questions. Firstly, how well do index funds promote better ESG corporate practices? And relatedly, how should investors select sustainable index funds?

Contrary to popular belief, “passive” investing can foster better ESG corporate practices in two ways. By deciding whether to invest or divest, a passive fund influences a firm’s cost of capital. Moreover, by engaging management and voting at general meetings investors can promote change. Empirical evidence suggests that both levers work, even for index funds. Additionally, improving firms’ ESG practices has the potential to create financial value for shareholders. 

However, there are meaningful differences in how well sustainable index funds deploy these two levers. For example, 28% of the 425 sustainable index funds we analysed, perform nothing more than a simple negative screening. Moreover, 37% of the sustainable index fund universe has a lower ESG score than their non-ESG parent benchmark, with only 28% of index funds having an ESG score which is at least 5% higher. Also, 16% of sustainable index funds use derivatives foregoing their right to vote, a key lever to promote sustainability. Overall, few sustainable index funds today meet simple ESG promotion criteria. For example, only 16% of sustainable index funds globally do more than focusing on a single theme or relying on a simple negative screening, while improving ESG scores by at least 5% and avoiding derivatives. 

Key Takeaways

  1. “Passive” investing can promote sustainability. Index investors impact firms’ cost of capital. Moreover, their voting and engagement triggers change. Interestingly, fostering ESG can also unlock financial value.
  2. Selecting sustainable index funds requires analysing funds across new dimensions. An investor should assess how well an index fund promotes his/her sustainability values. Moreover, s/he should check potential investment biases -such as style, country or sector- associated with an ESG strategy.
  3. Many sustainable index funds still have room for improvement. Key issues include using simple exclusions when having broader goals, not improving ESG scores and using derivatives.

Our paper in the Journal of Index Investing describes the framework in more detail.

Mercereau, Sertã and Gavini “Promoting Sustainability Using Passive Funds”, The Journal of Index Investing, Fall 2019.