Index construction for sustainable development investing

ABSTRACT

We implement the definition for Sustainable Development Investing (SDI) developed by the Global Investors for Sustainable Development (GISD) Alliance to construct an investable global SDI-aligned equity index. To this end, we create a proprietary methodology to rate companies’ SDI contribution using the Sustainable Development Goals (SDGs) as the appropriate unit of measurement. We find that the inclusion of SDI preferences in a multi-objective portfolio yields similar risk-return characteristics as a benchmark portfolio. This article informs institutional investors and index providers about practical approaches to implement the SDI definition with recently developed commercial data solutions. In this context, we review and provide an overview of data availability for the classification of companies’ alignment to the SDGs based on their products and services.

KEYWORDS:

• Sustainable Development Investing
• Sustainable Development Goals
• equity indices
• CSR ratings

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 The views expressed in this article do not necessarily reflect the views of any organizations, agencies or programmes of the United Nations. We are thankful for the support of the Financing for Sustainable Development Office of the United Nations Department of Economic and Social Affairs, especially Mathieu Verougstraete and Sander Glas.

2 Social transformation, agriculture and food system transformation, decarbonization and energy transformation, circular transformation, digital transformation, urban transformation, financial system transformation

3 Available online: https://sdgcompass.org/business-indicators/

4 The aggregate Refinitiv ESG Score consists of the environmental, social, and governance pillar scores. For more information, see: https://www.refinitiv.com/content/dam/marketing/en_us/documents/methodology/refinitiv-esg-scores-methodology.pdf

5 Eikon code: TR.RevenueEnvProducts

6 Eikon code: TR.PolicyWaterEfficiency

7 More information is available on their website: https://www.msci.com/what-if-esg-disclosures-become-standardized

8 Citation from the UN’s official website https://www.un.org/sustainabledevelopment/development-agenda/

9 We are thankful for the provision of data by Arabesque, SDI Asset Owner Platform, FTSE, ISS ESG, MSCI, Refinitiv, Sustainalytics, and Vigeo Eiris.

10 For more detail, see their methodology document available here: https://www.issgovernance.com/esg/impact-un-sdg/sustainability-solutions-assessment/

11 We are aware that these ESG ratings may not fully reflect the sustainability of companies and are constructed by aggregating public company disclosures. The inclusion of multiple ratings of different rating providers for the construction of the SDG-aligned index in intended to mitigate the biases that are inherent to these commercial sustainability assessments.

12 We also consider alternative weighting approaches, which are presented in Table A5. A comparison of the results in Table A4 shows that the "VW" and "Tracking" portfolios have a higher Sharpe ratio at lower SDI values. However, this is not due to differences in the SDI value or possible differences in the idiosyncratic risks of the portfolios: Given the portfolio concentration shown in Figure 4, Panel B and the portfolio risk shown in Figure 6, Panel C, it can be stated that the influence of idiosyncratic risks seems to be very small at SDI values between 12 and 15 (if present at all). Only at SDI values >15 does the portfolio concentration and also the portfolio risk increase sharply. The differences in the Sharpe ratios of the portfolios, on the other hand, are due to the fact that the "VW", "Tracking" and "Risk/Return/SDG" portfolios pursue completely different optimization criteria, which result in different portfolio concentrations and thus not directly comparable risk/return profiles. Considering the relationship between SDI and risk in Figure 6, Panel C and the relationship between SDI and return in Figure 5, Panel B, an SDI value of 15 seems to be optimal with regard to the Sharpe ratio for the "Risk/Return/SDG" portfolio.

13 Under these conditions, the portfolio can also be viewed as a tracking portfolio for which the additional restriction applies that a certain sustainability value should be achieved. Of course, the choice of an SDI score of 15 is to some extent arbitrary. In choosing the target value for the SDI score, we have assumed an investor who wants to achieve the highest possible SDI value without taking on too high concentration risks or too high idiosyncratic risks. Figure 6, panel A, shows that regardless of the beta of the portfolio, the risk starts to increase at an SDI score of >15. The reason for this is not that a particularly high SDI contribution is associated with a particularly high risk. The reason is rather that there are only very few assets with a score >15 (see also Figure 2). This leads to a considerable concentration in these assets (see also Figure 4, Panel B) and to a significant increase in idiosyncratic risk as shown in Figure 6, Panel A. In this respect, a target value of 15 appears to be the highest acceptable value.

14 Alternative approaches to integrating ESG aspects into portfolio construction can be found, for example, in Pedersen, Fitzgibbons, and Pomorski (2021). Similar to the approach of Gasser, Rammerstorfer, and Weinmayer (2017), this is based on an extension of the mean-variance approach.

15 For example, ESG Screen 17 (https://www.screen17.com) currently develops company ratings as regards all of the 17 SDGs.