ESG investment and direct indexing go hand-in-hand

Growth in direct indexing could help drive ESG-focused investments

by | October 18, 2021 | Meradia

Interest in ESG investing has grown dramatically. Over the past few years, awareness of social inequality and the dire consequences of climate change have accelerated both retail and institutional investment in ESG funds.

But ESG investment goes beyond allocating capital towards driving positive change, in many cases there is also a profit incentive pushing money into those products.

“There’s statistical proof that ESG-based investing can produce positive returns, which has attracted widespread investor attention,” says Richard E. Mailhos, principal at Meradia, an investment operations and technology consulting firm. “It’s also a feel good thing.”

According to Bloomberg, global ESG assets are expected to reach $53trn by 2025 and will account for one third of assets under management. Though there are a growing number of ESG- focused mutual funds and ETFs, direct indexing offers an alternative approach.

Direct indexing itself is a relatively new investment trend. As opposed to managed funds, direct indexing allows investors to select their allocations and exposures in a customisable way off the index.

“Direct indexing is a by-product of the desire to personalise your portfolio. It’s a viable alternative to traditional index investing that offers the opportunity to decide where your investments go, versus having someone choose for you,” says Mailhos.

This flexibility is one of several advantages of direct indexing, with investors able to pick and choose which components of an index to divest in and also decide on the weighting. For this reason, Mailhos believes the two trends of direct indexing and interest in ESG are interconnected.

“They started out as separate trends and are now colliding because they have similar end goals and – interestingly enough – similar administrative needs on the back end,” he says.

With direct indexing, investors can more closely scrutinise firms they feel are not doing enough to be environmentally sustainable and socially responsible.

Common ESG standards and taxonomy

However, there are many challenges that remain in ESG investments. One of the largest is on taxonomy and the potential of greenwashing.

“There’s inconsistent categorisation of ESG factors across the industry,” says Mailhos.

Based on the framework developed by the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures, regulators in several jurisdictions are already developing standardised ESG reporting and disclosures.

Establishing common standards and taxonomy for climate disclosures and ESG reporting has become a major official sector initiative. The EU, through the Sustainable Finance Disclosure Regulation, has already begun requiring asset managers and other market participants to publish environmental and sustainability risks of their products. In the UK, the Financial Conduct Authority is in the process of developing climate-related disclosures for listed firms.

Recent remarks from SEC Chair Gary Gensler also point to the US adopting mandatory ESG disclosures.

“Today’s investors are looking for consistent, comparable, and decision-useful disclosures around climate risk, human capital, and cybersecurity,” he told the US Senate Committee on banking, housing, and urban affairs.

“Companies and investors alike would benefit from clear rules of the road. I believe the SEC should step in when there’s this level of demand for information relevant to investors’ investment decisions.”

Without a common set of disclosure rules, Mailhos says, “it’s extremely difficult to institutionalise the administration of these portfolios due to a lack of standardised ESG ratings. The data management associated with [an inconsistent approach] is a fair struggle for most firms.”

“Going forward, we expect client reporting requirements to skyrocket as will the associated reference data, data management and systems used to monitor and maintain these investments. As firms work to satisfy these new demands, they will need to prepare for operational challenges like managing the hierarchy of rating sources and decisions on ESG ratings by company or investment instrument,” Mailhos remarks.





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