Indexology^® Blog

S&P DJI’s Tim Edwards explores how financial advisors can use index data, human behavior, and SPIVA® results to inform allocations and better understand assumptions about active fund performance.

https://www.youtube.com/watch?v=f-C_gRIBXvk

Key to evaluating core international equity benchmarks is an understanding of the country exposures offered. Developed and emerging market country classification differences between index providers may lead to notable geographic exposure differences across market segments. One of the most meaningful instances of this involves South Korea, which S&P DJI has classified as a developed market since 2001, while MSCI continues to classify the country as an emerging market.¹

In our latest blog in a series highlighting key features of the global equity benchmark landscape, we explore South Korea’s classification as a developed market and the impact of its inclusion within the MSCI Emerging Market indices.

South Korea’s Fit in the Developed Market Universe

S&P DJI annually conducts a complete review of all countries included in its global equity benchmarks. Similar to other index providers, this process involves an evaluation of markets by various economic and market accessibility criteria. S&P DJI has classified South Korea as a developed market since 2001 because of its high level of economic development, considerable size and liquidity, absence of significant foreign investment restrictions, and GDP per capita alignment with developed economies (see Exhibit 1). Over the years, S&P DJI has confirmed this classification through its annual country classification consultation process, which involves feedback from a wide range of market participants.

Viewed through the lens of company revenues on a geographic basis, the largest South Korean companies overwhelmingly gain revenues from developed economies. In comparison, the largest companies based in less-developed countries gain nearly all their revenues from other emerging economies. Therefore, the inclusion of South Korea in an emerging markets index leads to less underlying economic exposure to typically faster-growing emerging economies. A notable example of this phenomenon is Samsung Electronics, which is based in South Korea and derives approximately 59% of its revenue from developed markets and is the fourth largest position in MSCI Emerging Markets.

Crowding Out Less-Developed Countries   

While excluded from the S&P Emerging LargeMidCap, South Korea represents an outsized weight of 11.9% in MSCI Emerging Markets, potentially crowding out less-developed markets from the benchmark.

Since country exposure is a key driver of the risk and return of emerging market equities, it is imperative to fully understand your benchmark to ensure the exposure is consistent with the expected characteristics of emerging markets.

To learn more about the comprehensive coverage of the S&P Global BMI Index Series, see The S&P Global BMI: Providing Consistent Insights into Global Equity Markets since 1989.

¹ FTSE promoted South Korea’s standing in 2009.

In a recent webinar I moderated, Brie Williams of State Street Global Advisors joined me to discuss how environmental, social, and governance (ESG) data and investing are now at an important turning point. During that webinar, we answered some advisor questions. I encourage you to watch this replay if you missed it. We ran out of time to answer all the questions we received, so I thought it would be worthwhile to bring our discussion to Indexology to “extend our time” and, in that way, answer more questions advisors may have as they evaluate how and in what ways to position ESG investing. In this first post, I have grouped questions on the theme, “Why Now for ESG?” In a follow-up post, I will cover a second, related theme, “How Is the ESG Discussion Changing?”

Q: ESG has been around for a while. What is different now that should command our attention?

Brie Williams, State Street Global Advisors: When it comes to ESG investing, the world is changing. Investor engagement is growing while data and analytics that track the performance of these strategies are evolving. As a result, ESG adoption is accelerating.

• Globally, the percentage of retail and institutional investors that apply ESG principles to at least a quarter of their portfolios jumped from 48% in 2017 to 75% in 2019.¹
• Specific to scoring data, the more ESG data providers are investing in developing ESG scoring solutions, the more companies will prioritize reporting and disclosure. After all, we can only focus on financial materiality so distinctly because increased reporting in non-traditional areas has already been in motion.

Q: We always hear about incredible amounts of money tracking ESG, but is that all in other countries, or solely institutional clients? What do you see going on with ESG ETFs and mutual funds?

Brie: ESG is an evolving space and relatively small from an asset base and product offer space; however, development is becoming more dynamic and diverse, with new products and new issuers as well as conversions of existing products to ESG.

• Most of the assets lie in equity, where flows are favoring broad ESG over thematic.
• The industry is trending toward lower-cost solutions, with over 50% of U.S. ESG ETFs launched in the past two years having a net expense ratio under 20 bps.
• ETFs are helping to democratize access to ESG, enabling investors large and small to better realize their investment objectives.

And the cash flow story behind the ESG superhighway is dynamic.

• Sustainable funds attracted an estimated USD 45.7 billion in net flows globally during the first quarter of 2020, even while the overall fund universe suffered USD 384.7 billion in outflows as markets plunged in response to the pandemic.²
• We project a nearly eight-fold increase in global ESG ETF and indexed mutual fund assets, from USD 170 billion as of May 31, 2020, to more than USD 1.3 trillion by 2030.³

Q: Is ESG an idea with staying power, or is it a “flavor of the year” in the financial media and product marketing space?

Brie: Three trends are positioning ESG to transform from a check-the-box portfolio component to a significant component of a portfolio.

1. The great reset in a turbulent 2020, with “S” and “G” issues at the forefront

The management of “E” and “S” risks will likely emerge as the new standard of comprehensive corporate governance—and underscore how non-financial E, S, and G factors may affect long-term valuation.

2. Investors are reshaping what’s next. Industry transformation is under way, helping investors to:
   • Incorporate ESG factors for sustainable performance;
   • Rely on better data to make better decisions;
   • Gain ESG exposure with cost-effective ETFs; and
   • Customize portfolios with ESG funds.
3. Changing investment demographics

Large-scale wealth transfers—nearly USD 15.4 trillion in global wealth transferred by 2030⁴—and a greater emphasis on living according to values have encouraged ESG adoption. Those changes will presumably reverberate and be magnified through increased government regulation and institutional investments.

¹ BPN Paribas, “The ESG Global Survey 2019,” 2019.

² Morningstar, March 31, 2020.

³ State Street Global Advisors, June 2020, based on Morningstar data as of May 31, 2020.

⁴ Wealth-X, “A Generational Shift: Family Wealth Transfer Report 2019,” June 2019.

So far, 2020 has brought us a global pandemic, a coordinated global economic shutdown, and, in the U.S., a notably contentious election. So it’s no surprise that volatility has been, and remains, elevated. Despite all this, equities have fared reasonably (some would say surprisingly) well, with the S&P 500^® climbing 13% through Nov. 19 since the end of 2019.

The elevated volatility can be seen across all sectors of the S&P 500 relative to the beginning of the year, despite having declined a bit in the past three months. The highest volatility sectors continue to be Energy and Financials.

The latest rebalance for the S&P 500 Low Volatility Index (effective after market close Nov. 20, 2020) wrought minimal changes. Only eight names, accounting for about 7% of the index’s weight, cycled out of the index. The Energy, Financials, and Utilities sectors, traditionally low volatility stalwarts, continued to hold only a small fraction of the portfolio. Consumer Staples and Health Care together accounted for just over 50% of the rebalanced portfolio’s weight, as our methodology targets the 100 least volatile stocks in the benchmark S&P 500.

I define core ESG indexing as the use of indices designed to apply environmental, social, and governance (ESG) screening and ESG scores to recognized and sometimes iconic indices like the S&P 500^®, S&P/ASX 200, or S&P/TSX Composite. These headline indices become actionable components of asset allocation when a fund or separately managed accounts (SMA) provider tracks the index. Our SPIVA^® and Persistence Scorecards prove time and again that these well-designed indices are fit for that purpose. Now we have designed and launched core ESG versions of these indices to leverage SAM’s¹ robust ESG data to measure the ESG engagement of companies in the benchmark index. Looking at the cost and availability of the ETFs that currently exist in the U.S., U.K./Europe, Canada, and Australia in this core ESG category, it is fair to say that the partnership of index providers, ETF data providers, asset managers, and market makers has democratized access to ESG for strategic allocation. But it’s okay with me if you prefer to think of that use of ESG as thematic rather than strategic.

How exactly is core ESG indexing engaged to drive the types of change that ESG investors want to see? At first glance, most core ESG indices are not excluding as many industries or companies as ESG “leader” indices. The conscious design difference in core ESG has helped to historically ensure that core ESG indices track their benchmark closely. Yet the core ESG selection of eligible companies based on ESG score leads to industry and sector differences we can see. Exhibit 1 shows the last company selected and the next company not selected based on ESG scores for some of the industries within the S&P 500. Sector weight information is available free on spglobal.com/spdji, showing sector weight differences between benchmark and ESG indices.

At the company level, our expectation is that CFOs are engaged in addressing ESG inquiries from firms like SAM. SAM accesses both public and non-public information to render scores. This inquiry and reporting drives people and process changes at these companies as they attempt to improve year over year. And those same CFOs try to ensure their company is selected in core ESG indices. As investor demand for ESG continues to increase, my expectation is that selection in the S&P 500 ESG Index will matter to CFOs in a similar way to how selection matters in one of our Dividend Aristocrats^® indices.

Another aspect of engagement that core ESG indices drive is bringing more transparency to how companies are managing material nonfinancial risks and opportunities. Is that information relevant to company valuation? A growing field of accountancy as well as education and training practice led by universities and the Sustainability Accounting Standards Board (SASB) are making that point, and I think that point is often missed by advisors and investors of my generation. We were trained to look at the three financial statements of the firm. We may need to have it pointed out to us how substantial the shift has been in valuation to intangible assets. Exhibit 2 illuminates this point in the ubiquitous S&P 500 by showing how intangible assets have increased significantly as a driver of market capitalization for the top five companies in the index over time.

Exhibit 2 shows that we need to be more curious about how ESG can provide information about intangible assets and nonfinancial risks and opportunities. More information and data from ESG data providers like SAM will paint a more complete picture of how to measure the long-term sustainable performance of equity and fixed income asset classes.

¹ SAM, part of S&P Global, provides the data that powers the globally recognized Dow Jones Sustainability Indices, S&P 500 ESG Index, and others in the S&P ESG Index Series. Each year, SAM conducts the Corporate Sustainability Assessment, an ESG analysis of over 7,300 companies. The CSA has produced one of the world’s most comprehensive databases of financially material sustainability information, and serves as the basis for the scores that govern S&P DJI ESG indices.