This blog was originally posted here on 26 May 2020. It is reprinted with permission.

The world of Environmental, Social and Governance (ESG) indexes has never been bigger, it seems everyone who has an index wants to get in the game. Since the release of the first “Sustainability Index” by Dow Jones, where I was the first managing director, the construction and production of ‘sustainability’ or ‘ESG’ indices has exploded and can be found on every exchange for all sizes of companies.

Yet… they are just carbon copies of themselves. Where is the innovation? 

The environment has morphed; where the market has seen a shift in what is expected of companies. The flows into passive ESG products has been steadily rising over the last few years. Indeed, the ESG flow fund, calculated by Calastone proves the popularity of ESG as a viable investment strategy. “Calastone’s ESG Fund Flow Index averaged 61.9 over the last three years, meaning that buying activity was almost two thirds larger than selling activity, outshining all other fund categories.”[1] Too bad each of the ESG indices which have been constructed, or will be constructed are carbon copies of each other, the only thing that changes is the name of the data providers.

The demand for passive products could not be any more ‘woke.’ In a recent report from Morningstar, capital inflows to sustainability is taking the markets by storm. The data shows that globally, sustainable funds saw capital inflows of $45.6bn (£37.2bn) during the first quarter of 2020, effectively avoiding the Covid-19 sell off.[2] Investing in ESG is good financial business and makes good financial sense. Yet, the same tired ways of investing in ESG continues to be the norm.

I would posit that passive investors deserve products that are innovative and fresh, aligning with the changes in environment and expectation of companies and brands. The need that investors have for innovative and fresh products also applies to the methodology used by indexes. Also, the old adage that rubbish in, rubbish out also goes for the methodology used by the indexes. The data, as it stands today, is old or incomplete, no one knows if the data is riddled with errors, the data is not verified at a granular level and assurance covers only a small percentage of the data. Is it not time for index providers to move to the next level; using new technology and demanding more from the data and thus the methodology? Unfortunately, for someone who has been in the field of sustainable finance for nearly 30 years and was at the forefront of ESG indexes, I am disappointed by the lack of innovation. Indexing should have moved on in the last 20 years.

As a side note: while I served as the first managing director of the Dow Jones Sustainability Index, it was overseen by an enlightened board that was ahead of its time formed by; David Moran, John Presbo, Mike Petronella, Richard Sandor and Reto Rigger. The Dow Jones Sustainability Index under the auspices of this illustrious group forged the path for other indexes, we knew what needed to be done, we could see the need for such a tool for passive investors, saw the strength in non-financial information leading to informed investment decisions, and we got it done.

If that index was to be launched now, I would expect that the board would demand more from the index than just a listing of equities with filters using old and stale ESG data, scraped from the internet with little evidence of what ‘good’ looks like. What is missing is the real innovation capturing the diversity of potential products and need for better data.

In 2016, the Singapore iEdge SG ESG Leaders Index was launched measuring the performance of the Singapore stock exchange (SGX) listed companies with leading ESG practices. iEdge has seen on average a 40% return since mid-March.[3] ESG is galvanising investment in those index constituents which are listed as ESG leaders, especially from institutional money. They are the only index that I have been privy, which is moving to more innovative products.

In Europe, the Deutsche Börse Group has also decided to participate in the ESG market with its index and analytics business, Qontigo. In March of this year, Qontigo launched DAX 50 ESG index. Exciting times and with the strength of the German market, it has real possibility. But reading beyond headlines, the index will be built on antiquated methodology. A methodology that I used, successfully, at Dow Jones over 20 years ago. The construction of the index uses, “[…] norm-based exclusion criteria are applied in accordance with the UN Global Compact Principles, and also product involvement screening for controversial weapons, tobacco, coal, nuclear power and military contracts.”[4] What is new about that? Creating an index, just because of the capital inflows, does not show innovation.

Where is the creativity and innovation that inspired the first sustainability index? There are so many opportunities to be leaders in the development and deployment of sustainability/ESG indexes. But those who would be leaders are not taking the opportunity to lead. We, who have been in this field for decades, know that it is time for enhancing the current status, and proactively moving beyond screening to moving the needle, where passive investors can be part of the solution in delivering sustainable and true impact.

Investors are crying out for innovative products that show real impact: environment, social and economic; as non-financial or ESG becomes more important to the resilience of a company than financial. Also, with regulation leading the way, indexes can no longer sit on the side-lines, but must be compliant with legislation as well as demonstrating impact. No longer is innovation ‘negative or positive filtering,’ but companies which are seen as ESG leaders must show a positive contribution to society, building new business strategies on the changing business environment and be truly resilient to major crises – such as climate change and pandemics. Filtering and antiquated methodologies, on which indexes are staking their successes, does not reflect an accurate picture of companies performance, and thus the needs of investors, legislation or the planet.

Newly launched indexes could take the lead, but they are rehashing old ideas. Therefore, the result: Business as usual, with an expectation that indexes will move to the next level and start to be innovative, again.

Imagine a world where index innovation would encourage even more investment, where out-performance was the norm and society and the environment would be demonstrably better.