Indexology^® Blog

Where can environmental, social, and governance (ESG) benchmarks help investors and markets most? The answer may be in emerging markets, where it is crucially important to identify and navigate ESG concerns. The transparency that ESG benchmarks provide can help investors distinguish companies that prioritize the needs of not just their shareholders, but also their many additional stakeholders, including their employees, the communities they operate in, and the environment around them.

However, to truly drive change, an ESG index must be more than a flag to wave—it must set the foundation for investment. The S&P/BMV Total Mexico ESG Index, launched on June 22, 2020, is one such benchmark, built for investors looking for a tool to help them act.

The S&P/BMV Total Mexico ESG Index is built with the same philosophy underpinning the creation of many popular new ESG indices around the world, such as the S&P 500 ESG Index. The idea is that certain ESG indices should be more inclusive than exclusive to remain broad and diversified, such that the ESG index has a similar overall industry group weight as the benchmark, while providing an improved ESG profile.

Exhibit 1 shows how this index is constructed. First, exclusions are made according to companies’ involvement in business activities related to tobacco or controversial weapons or low compliance with the United Nations Global Compact (UNGC). Next, the S&P DJI ESG Score is used to screen and select companies. Finally, companies are weighted by their ESG Score.

The result is an index that, at launch, retained 29 of the 56 companies in its benchmark index, the S&P/BMV Total Mexico Index. By maintaining more than half of the original number of constituents and selecting companies within their industries, the index remains relatively balanced from a sector perspective. Exhibit 2 shows the average sector exposure of the ESG index and the benchmark index from the time S&P DJI had enough ESG data to calculate this index.

Because of the sector alignment and the ESG index constituents exhibiting an average beta of nearly 1—1.02 to be exact—the indices have historically performed largely in line with each other. This is attractive to many investors seeking to integrate ESG into their portfolios at a manageable level of risk.

In addition to this new index having achieved a similar risk/return profile as the market historically, market participants are also investing in better-performing companies from an ESG perspective—companies that align with their values. At launch, the composite ESG score for the S&P/BMV Total Mexico ESG Index was 59.6, a full 17 points higher than the composite score of its non-ESG benchmark index.

What does this higher score practically mean? It means more exposure to companies that have governance structures, human capital development, and environmental impacts better than their peers and in line with international standards, among many other positive qualifications. Further, it means that an investor using this index is aligning their investments with their values, thereby driving change in Mexico, creating a hopeful and sustainable future.

Volatility, dispersion, and correlation are elements of what we’ve elsewhere characterized as The Active Manager’s Conundrum. Active managers should prefer:

• Low volatility, which is typically associated with higher returns
• High dispersion, which means a larger payoff for correct stock selections
• High correlation, which reduces the opportunity cost of a concentrated portfolio

The conundrum arises because low volatility, high dispersion, and high correlation almost never occur at the same time.

An excellent example of this conundrum lies within the Kensho New Economy Indices. From our Q2 S&P Kensho New Economies Dashboard, Exhibit 1 illustrates that the Kensho sectors have much higher dispersion levels than the traditional S&P 500 GICS sectors. Interestingly, the Kensho sectors also have much lower correlations compared to their S&P 500 counterparts, unsurprisingly given the more idiosyncratic nature of their constituents compared to those within the GICS framework.

The results are even more striking in Exhibit 2, where we compare the S&P 500 GICS sectors to the Kensho subsectors, which have higher dispersion levels along with extremely low correlations.

Active managers, almost by definition, run less diversified, more volatile portfolios than their index counterparts. When correlations are high, the incremental volatility associated with being less diversified and more concentrated declines.  We define the cost of concentration as the ratio of the average volatility of the component assets to the volatility of a portfolio.  A higher cost of concentration implies a higher hurdle for active managers to overcome.

Applying this logic to the Kensho New Economies, we would expect the cost of concentration for the S&P Kensho New Economies Composite to be higher than that of the S&P 500, as its low correlations create the possibility of less incremental portfolio volatility. We observe this to be the case in Exhibit 3, which shows that this cost is consistently higher for Kensho through time.

This analysis has important implications for active management. Because of their high dispersion, there are immense opportunities for stock-pickers to add value by choosing among names in the Kensho New Economy Indices. But doing so requires active portfolios to bear a higher cost of concentration; the low correlation among the New Economies names means that stock-pickers forgo a huge diversification benefit.  Investors who choose active management couple the possibility of higher returns with the certainty of higher volatility.

On June 25, 2020, the German digital payment company Wirecard AG filed for insolvency following reports that over USD 2 billion in cash assets went missing. Wirecard’s stock has gone down 90% since the initial announcement, and the company’s lenders now face deep losses.

While the S&P ESG Index Series does not include Wirecard, the case sheds light on how governance factors are incorporated and controversies are monitored in screening companies included in many ESG indices and benchmarks.

The primary driver of constituent eligibility and selection into the S&P ESG Index Series is a company’s S&P DJI ESG Score, which is derived from the annual SAM Corporate Sustainability Assessment (CSA). The CSA is an industry-specific questionnaire based on financial materiality and is designed to source corporate sustainability information directly from companies and used to assign ESG scores. Insights gathered from the CSA form the backbone of the ESG score that is incorporated in the index constituent selection process.

In each S&P ESG Index, companies are removed from eligibility due to involvement in controversial weapons or tobacco (in line with specific revenue thresholds) or for having a low United Nations Global Compact score. In addition, companies with an S&P DJI ESG score in the bottom 25% by Global Industry Classification Standard® (GICS®) industry group on a global basis are also ineligible.[1] At the most recent annual rebalance, effective at the end of April 2020, Wirecard had an ESG score of 10 (out of a possible 100),[2] which is firmly within the range of excluded ESG scores. As a result, Wirecard was not eligible to be selected for any of the indices in the S&P ESG Index Series.

What stands out in Wirecard’s ESG score is its poor governance performance. The company received a score of 4 (out of 100) in the governance dimension in the most recent review cycle for the CSA. This low score is primarily driven by poor performance in the areas of privacy protection, risk and crisis management, and codes of business conduct. Given Wirecard’s recent public struggles, its already low governance score reflected this weakness.

Wirecard, in fact, has never been part of any S&P ESG Index. At each historical rebalance period dating back to 2018 (the first rebalancing when Wirecard was in a universe index for the S&P ESG Index Series), the company never broke the 25% score threshold for eligibility.

It is worth mentioning that in the vast majority of S&P DJI’s ESG benchmarks, including the S&P ESG Index Series, corporate controversies are monitored on an ongoing basis through a Media & Stakeholder Analysis (MSA).[3] When controversies occur between index rebalances, they are factored into the decision of whether or not a company’s ESG score should be reduced. An S&P DJI Index Committee, which oversees the index, assesses the revised ESG score to determine whether the company continues to meet the eligibility criteria and therefore should remain in or be removed from an index. Even though Wirecard was not in any S&P ESG Index and thus could not trigger this process, the S&P ESG Index Series does have measures in place to account for controversies affecting current constituents.

Wirecard’s struggles with governance are well documented by now. The financial-materiality-driven CSA framework was designed to identify a company’s sustainability performance from an ESG perspective. The combination of Wirecard’s ESG score plus the S&P ESG Index Series methodology appears to be fulfilling its intended design.

[1] For more information, please refer to the S&P ESG Index Series methodology.

[2] S&P DJI ESG Scores are designed to be read as percentiles; in the case of Wirecard, a score of 10 means that the company is in the bottom 10^th percentile globally within its industry.

[3] For more information on the MSA, please refer to the MSA Methodology Guidebook.

During the months of March to May this year, dividend concerns came to the fore as many companies, globally, announced cuts, cancellations, and postponements to their respective dividend programs. We examined the impact of these public announcements on the S&P DJI Dividend Indices, and our assessment then revealed that the extent to which indices were affected varied regionally. Companies within U.S. indices, for example, saw limited negative dividend action, while in Europe, it was a rather different picture.

Results from the June 2020 Annual Review

A number of indices, including the S&P Euro High Yield Dividend Aristocrats® (S&P Euro HYDA), S&P UK High Yield Dividend Aristocrats Index (S&P UK HYDA), and Dow Jones Select Dividend Indices,¹ underwent annual reviews in June (effective as of the June 22, 2020, open). The rebalance produced significant changes (see Exhibit 1), which we highlight in this blog. Unsurprisingly, it was a high turnover event that led to meaningful sectors shifts for many of the indices. Additionally, a couple of indices also had methodology changes, resulting in a revised target number of constituents in those indices.

A Major Turnover Event by Historical Standards

Almost all the dividend indices experienced one-way turnover of 35% or higher, with the exception of the Dow Jones U.S. Select Dividend Index. The turnover figures were considerably higher with historical context, as shown in Exhibit 2, where we investigated annual rebalances going back to 2015.² Interestingly, however, the turnovers for the S&P Euro HYDA and S&P UK HYDA were lower compared with those of the Global Financial Crisis period (2008/2009, c.70%).

S&P UK HYDA and Dow Jones Asia/Pacific Select Dividend 50 Index Rule Changes

The UK HYDA and Dow Jones Asia/Pacific Select Dividend 50 Index, which were among the top three in turnover, instituted changes to their respective index construction methodologies, effective at this latest review. Brief highlights of the changes are as follows:³

• The S&P UK HYDA—Previous index rules targeted 40 stocks based on a rank of companies that had increased or maintained dividends for seven consecutive years. This was relaxed down to four consecutive years to ensure that a target of 40 stocks was met. Under the new rules, the constituent count may vary between 30 and 40, subject to the same dividend payment constraints as per previous rules. However, should the eligible number of stocks dip below 30, the number of consecutive years of dividend payments would be relaxed further to three years.
• The Dow Jones Asia/Pacific Select Dividend 50 Index (DJ APAC Select Div 50)—This index was previously called the Dow Jones Asia/Pacific Select Dividend 30 Index. As the name change suggests, the target number of constituents was increased from 30 to 50.

The significant increase in number of constituents for the DJ APAC Select Div 50 was the likely driver of high turnover at the June 2020 review. However, this was unlikely to be the case for the S&P UK HYDA, for which the scale of dividend cuts and cancellations within the index was the likely contributor.

Dividend Strategies Rotated Out of Consumer Discretionary

The high turnover of the rebalance was accompanied by significant sector shifts, as shown in Exhibit 3. The rotation comes after four-plus years (since 2017⁴) of relatively stable sector weights for many of the indices. While a material down-weight in Consumer Discretionary was a common theme, the beneficiaries were varied across the indices analyzed. Consumer Staples, for example, saw a considerable weight increase in the S&P Euro HYDA and S&P UK HYDA and Financials was the winner in the Dow Jones U.S. Select Dividend Index. Notably, of the eight indices listed in Exhibit 1, Financials is now the largest weight in six of them, rising from two, pre-rebalance.

¹Postponed from its regular annual rebalance schedule in March every year.

²Index turnover was analyzed from 2015 onward, as many indices had been subject to methodology changes prior to 2014.

³For a methodology overview of the S&P Dividend Aristocrats and Dow Jones Select Dividend Indices, please refer to S&P DJI’s Dividend Indices: The Importance of Incorporating Quality Screens.

⁴The GICS® Real Estate sector was introduced in 2017.

After a volatile start to 2020, many investors were looking at double digit declines and were probably re-evaluating their 2020 expected returns. But while COVID-19 continued to determine market sentiment, Q2 hosted a remarkable recovery.  The S&P 500 (+20.54%) and the S&P MidCap 400 (+24.07%) posted their highest quarterly total returns since 1998, while the S&P SmallCap 600 (+21.94%) recorded its largest ever quarterly gain.

More broadly, the overwhelming majority of sector and style indices across the market capitalization spectrum also recovered in Q2: 14 posted their best quarterly total return ever as stimulus packages and tentative indications of a reopening U.S. economy offered tailwinds.  Energy led the way, helped by gains in commodity markets, followed by Consumer Discretionary and Information Technology.

Although a move from spring to summer usually causes a shift in style – at least on the clothing front – there was little change from an investment perspective: growth continued to outperform value, as it has done for most of the last decade.  However, the magnitude of growth’s outperformance during the first half of 2020 was unprecedented: we saw the highest spread in growth and value YTD total returns compared to the first six months of any other year since 1998. Declining U.S. Treasury yields, and the impact on valuations of growth-oriented companies likely helped.

The strong gains observed in Q2 and a mostly positive start to this month have brought certain indices to within striking distance of their 2020 highs: the S&P 500 Information Technology sector needs another 1% in gains, while the Tech-heavy S&P 500 Growth (0.9%) needs slightly less. In contrast, large gains are still needed in the Energy sectors to recover recent highs: the asymmetric impact of drawdowns meant Q2’s gains were not enough to overcome the precipitous declines from the first quarter.

So where does that leave us? Timing the market is challenging and has arguably been made harder by how unusual 2020 has been so far.  While it’s anyone’s guess what might happen during the rest of the year, the first half of 2020 suggests it may be memorable and interesting to watch.