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December 13, 2012

Major Stock Market Indexes can Elevate ESG Risk for Investors
    by Robert Kropp

A study by GMI Ratings analyzes the environmental, social, and corporate governance performance of major stock market indexes, and finds that most perform poorly against the research firm's normative distribution.

SocialFunds.com -- Investors typically benchmark the performance of their portfolios against stock market indexes such as the Nasdaq 100, S&P 500, FTSE 100, and MSCI World. Investors and portfolio managers use indexes to compare their investments against a representation of the overall market.

The indexes themselves vary widely in their components. The S&P 500, for instance, includes the largest US-based companies in industry sectors with the greatest effect on the nation's economy. Information technology, financials, health care, and energy are among the index's largest industry sectors; at present, the largest companies by market capitalization included are Apple, ExxonMobil, and GE.

But is the S&P 500 aligned with the environmental, social, and corporate governance (ESG) criteria sought by sustainable investors? According to a new study by GMI Ratings, not so much.

GMI researches the ESG and accounting risk performances of public companies, and uses its research to rank them. According to the study, fully 40% of S&P 500 companies are among the worst in ESG performance, compared to 20% for the normative distribution. High-performing companies are underrepresented in the index as well.

Furthermore, 30% of S&P 500 companies are in the lowest quintile of GMI's ratings on accounting risk.

The Nasdaq 100, which excludes financials but includes international as well as domestic components, also performed poorly against GMI's normative distribution for ESG and accounting risk, as did the MSCI World, which excludes developing markets.

Of the indexes analyzed by GMI, only the FTSE 100 outperformed the normative distribution. The components of the FTSE 100 represent about 81% of the market capitalization of the London Stock Exchange, and include companies headquartered in emerging market countries.

What are the implications of GMI's study for sustainable investors? It may be instructive to compare it to a recent analysis by oekom research, which found that a portfolio comprised of its top sustainability large-caps would outperform the MSCI World index by a wide margin, and exhibit less volatility as well.

The outperformance of the FTSE 100 in GMI's study also suggests that with the persistent low returns and volatility prevailing in developed markets since the financial crisis, emerging markets have become an increasingly attractive investment strategy.

"Institutional investors typically use index benchmarks as a way to measure their contribution to performance," James Kaplan, chief executive of GMI Ratings, said. "However, our findings suggest that widely followed indices such as S&P 500 can also expose investors to above-normal concentrations of ESG and accounting risk."

"So far, the financial community has mainly started to apply extra-financial research to the analysis of individual stocks," Kaplan continued. GMI's analysis "point to the importance of applying these novel measures more broadly not only to indices but also to asset classes and industry groups."

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