Responsible Index Investing: Reimagining How to Access Returns

Passive investment has, for some time now, been steadily gaining investor interest globally. More recently this trend has started to pick up among South African (SA) investors, who are looking for lower fees for domestic market exposure. The latest retirement reform initiatives by the SA Government have created even more interest in passive investing and index tracker investment products. However, with the launch of sustainability indices from the JSE and Standard & Poor’s in SA last year, a new trend is starting to emerge in the passive investment space, with the spotlight on the growth of benchmarks offering environmental, social and governance (ESG) principles led-mandates. 

Judith Rodin recently wrote an article in Fortune Magazine entitled ‘The end of short-termism’, which stated: “For generations, shareholders have warned corporate managers NOT to let environmental, social & governance responsibility eat into their profits. But a growing cohort of investors is sending a new message: Do good, or we’ll walk.”  Judith’s research shows that this is no idle threat as global assets managed according to ESG principles doubled to more than $6 trillion between 2012 and 2014.

ESG led sourcing, operating and innovating for higher returns

This may sound impressive but is just the start. Among the Millennials – the demographic group that will inherit more than US$30 trillion over the next few decades, 92% believe that a company’s competitive edge and profitability will actually be enhanced by investing responsibly. As a result, companies are reimagining how they source, operate and innovate to advance a healthier planet, which they believe will ultimately produce higher returns for their investors.

Predicting this trend, MSCI led the market by launching their first ESG index in 2007. Today they have 200 dedicated ESG analysts that rate the 2 400 World and Emerging Market companies, producing 30 page reports on each – every year. To minimise tracking error relative to the original MSCI market capitalisation indices, stocks are ranked within each sector. 50% of the worst ranked stocks per sector are then removed. This methodology therefore doubles overweight exposure to management teams that are demonstrating ESG leadership within their peer group. This translates into a low-risk strategy with potential average annual excess returns above MSCI All Country World Index of approximately 1%. Old Mutual Investment Group launched this capability in January 2015 and has already seen inflows of over US$240 million.  

Making the ESG grade

So what criteria determine whether a company is included or excluded in an ESG index? Essentially it is companies making genuine ESG efforts to positively impact the world, as they tend to reap far greater profitable rewards than companies that are behind the curve. This is demonstrated in a number of examples.

Starbucks: Walking an extra block (Included in the MSCI World ESG Index)

Howard Schultz, the founder of Starbucks stepped away from the day-to-day management of the business in 2000. By 2007, the company was in a terrible downward spiral, declining by 42% in that year alone. When Schultz stepped back into the fray in 2008, his initial ascertain was that Starbucks had become a soulless company. Core to his turnaround strategy was a belief that, ‘consumers are willing to walk another block and spend a little more for companies whose values they truly trust.’  This is no small challenge when you consider that this was at the height of the financial crisis that was driving consumers to cut back on US$4 lattes.  

So how did he go about putting the soul back into Starbucks? By investing in his staff and ignoring short-term quarterly earnings calls. Given the economic slump, Schultz was under huge pressure to cut costs by removing healthcare benefits – which are typically not offered to hourly paid workers. He refused and has since instituted something even more astounding by offering four-year on-line bachelor’s degrees via Arizona State University, to all full- and part-time employees – that’s 140 000 out of a total of 191 000 employees. To top this off,  here is that there is no obligation to remain at Starbucks after graduation.

I can personally attest to walking an extra block in places like New York to find a Starbucks to experience the energy and productivity that comes from happy, motivated staff.  Howard Schultz ‘gets’ that he cannot personally manage 21 000 stores in 65 countries, but by doing good and thinking long term he has created a culture of loyal barristers who want nothing more than to sell you a US$4 pumpkin-spiced latte.

Walmart: Who’s paying my salary? (Excluded from the MSCI World ESG Index)

US$7.8 billion is the estimated salary contribution that the American Government is indirectly paying to Walmart via social subsidies provided to their 500 000 strong US workforce – these include food stamps, housing, childcare and healthcare grants. Clearly something is out of whack? These employees might have a job but they are below the breadline and are being seen by management as a cost driver not as a sales driver. As you can imagine, morale, productivity and customer service at Walmart is poor and competitors – like Costco – continue to eat their lunch.

As a result of this public, government and investor pressure, Walmart has recently increased their minimum wage to US$9 an hour which will have a significant impact on operating profit – forecast to be down 8% for the year. So with this pay increase, has Walmart’s business model become more sustainable? The answer is a resounding no. To put this into perspective, Costco pays its workers over $20 an hour, which is more than double the Walmart wage. Therefore, the hidden costs embedded with this business remain a huge concern.

It is worth pointing out, however, that from an environmental perspective, as the world’s largest retailer, Massmart is placing significant pressure on its thousands of suppliers to eliminate greenhouse gas emissions and increase recycled materials within their packaging. This is an example of a company getting it very right in certain areas but very wrong in others. Unfortunately for Walmart, inclusion in the MSCI ESG indices requires management to proactively tackle the ‘E’, ‘S’ and ‘G’ components of responsible investment equally.

A sustainable practical solution

For SA institutional investors seeking to support ESG investing by voting with their pockets without taking on material benchmark underperformance risk, ESG indices are increasingly providing a viable, cost effective solution, while offering a practical alternative to the unsustainable practices of many listed companies across the world.

Read more about our Indexation capabilities 

If you are interested in these capabilities, please contact:

Janina Slawski

Head of Institutional Distribution

Old Mutual Investment Group

JSlawski@oldmutualinvest.com