How to build a more ESG-friendly U.S. equity index

Enhanced index construction methodology targets 10% improvement in ESG scores while still closely tracking the parent benchmark

How to build a more ESG-friendly U.S. equity index

While investors and advisors might want to incorporate ESG into their portfolios, this could be a challenge for passive investors who want to avoid tracking error. But a new offering from FTSE Russell promises to eliminate that barrier.

The index provider has developed a new series of benchmarks, the Russell US ESG Indexes, which display better ESG characteristics than their parent Russell 1000, 2000, and 3000 index universes but still exhibit similar risk and return characteristics.

As explained in a white paper titled Incorporating ESG into US equity benchmarks, the new indexes are constructed according to the Russell US ESG Enhanced methodology. It starts by applying an exclusion screen to U.S. equity indexes, removing or cutting back exposure to companies involved in the controversial weapons, firearms, tobacco, and fossil fuels industries.

“Companies in the underlying index universes are researched annually for eligibility against the screens based on publicly reported information,” the paper said. “In addition, companies that fail a controversy screen are excluded. This assessment is made based on media screening to identify ‘on the ground’ activities that violate the principles of the Global Compact.”

According to the paper, the exclusion screens are applied on a quarterly basis in March, June, September, and December. The targeted outcome, it said, is to create a new benchmark with a 10% higher ESG score than the parent U.S. equity index, based on Refinitiv ESG scoring, while maintaining a low tracking error, factor neutrality, and beta close to 1.

“The scoring methodology captures over 450 company-level ESG measures, of which a subset of 186 of the most comparable and material, per industry, power the overall company assessment and scoring process,” the paper said. 

To minimize the tracking error relative to the parent index, FTSE Russell uses a target exposure approach that’s based on the firm’s transparent tilt methodology. By multiplying a benchmark’s weights by a certain factor, it can neutralize its active industry exposure while still controlling for tracking error and beta.

“[T]he tilting outcomes are transparent and therefore can support ESG-related stewardship activities and stakeholder communication,” the paper said. “As new ESG data become available or scores in the index universe improve, the investor is able to ‘raise the bar’ for ESG improvement as needed.”

Applying the methodology to the Russell 1000, the paper said, results in the exclusion of 70 stocks, with nearly half due to fossil fuel exclusions. All in all, the excluded companies represent a little over 6% of the original Russell 1000 benchmark.

The resulting Russell 1000 ESG Enhanced Target Exposure Index, according to the paper, was able to beat its parent Russell 1000 benchmark’s annualized performance from December 2016 through August 2021 by 97 basis points, with comparable volatility and a tracking error of 0.92%.

“[B]oth correlation (0.999) and beta (0.987) have been very close to 1 over the last 4.5 year period,” the paper added.