ESG Insights (Jan 2024): The Role of Sustainability Indexes in Sovereign Wealth Fund Portfolios

The Role of Sustainability Indexes in Sovereign Wealth Fund Portfolios

A sovereign wealth fund (SWF) is a state-owned investment fund that is established to stabilise the country’s economy through investment diversification and to generate wealth for future generations.? Given their large investment portfolios and long-term horizons, SWFs are uniquely positioned to accelerate the global shift towards sustainable investing. In fact, 79% of SWFs now have an environmental, social, and governance (ESG) policy in place, compared with 46% in 2017, according to Invesco’s 2023 Global Sovereign Asset Management Study[1].

Factoring ESG into the investment process has become increasingly important for SWFs for the following reasons:

Risk Mitigation: ESG analysis helps identify potential risks associated with factors like climate change, demographic shifts, and poor governance practices. By integrating ESG performance metrics, SWFs can effectively reduce tail risk and lower the probability of extreme losses. For instance, a multinational car company admitted to manipulating emissions tests, and resulted in a market capitalisation loss of over a third in just two days. By considering ESG factors, SWFs can reduce the likelihood of their portfolios being exposed to such events.

Long-term value creation: SWFs naturally align with sustainable investing due to their long-term focus on value creation.? Norway's Government Pension Fund Global (GPFG), one of the largest SWFs globally states that ‘the fund’s long-term return is dependent on a sustainable economy, well-functioning markets and good corporate governance[2]. In fact, companies that prioritise ESG factors have demonstrated superior long-term performance, as highlighted in our previous article[3].? By strategically selecting investments that adhere to ESG principles, SWFs can effectively navigate market dynamics and capitalise on the growing demand for sustainable solutions.

Stakeholder engagement: The integration of ESG factors by SWFs enables them to contribute to global sustainability goals while bolstering their image as responsible corporate citizen. A focus on ESG and impact investing allows SWFs to operate in line with evolving community standards of ethics and accountability for the benefit of current and future generations.

Adoption of Sustainability Indexes by SWFs

While the increasing number of SWFs establishing ESG policies is a positive sign, many of them still face meaningful challenges in translating commitments into coherent and impactful strategies on the ground.? This is particularly true for smaller SWFs that often face limitations due to a lack of available data and expertise gaps.? One powerful tool that can assist SWFs in this endeavor is indexing.? A sustainability index provides a benchmark for SWFs to align their portfolios with broader sustainability goals.? By leveraging such indexes, SWFs can strategically invest in companies that demonstrate exceptional ESG performance or possess a lower carbon footprint. SWFs can also customise a sustainability index to systematically exclude companies and sectors that do not meet their responsible investment strategies.? Furthermore, thematic indexes provide SWFs with the opportunity to focus on specific ESG goals, such as fostering a just and equitable green transition. For an overview of ESG index methodologies, please refer to our previous article[4]. Exhibit 1 presents some use cases among major SWFs.

Meanwhile, sustainability index can also support bottom-up portfolio management.? SWFs can leverage the data and analysis behind sustainability indexes to formulate its engagement and voting strategies. Additionally, the adoption of sustainability indexes can incentivise listed companies to enhance their ESG disclosure and performance, thereby attracting more capital investment from SWFs.

Ongoing Developments to Address Challenges in Sustainability Indexes

Sustainability indexes offer a cost-effective approach to integrating sustainability criteria into investment decisions and aligning portfolios with responsible and ethical practices. However, the adoption of these indexes presents challenges, particularly regarding the availability and quality of ESG data. Robust and reliable data is crucial for accurately assessing companies’ ESG performance and constructing representative ESG indexes. Yet, data gaps, inconsistent reporting standards, and diverse data sources often lead to challenges in acquiring comprehensive and timely ESG information. To address this issue, data providers, regulators, and market participants are collaborating to enhance data collection, transparency, and accessibility.

For instance, the International Financial Reporting Standards (IFRS) Foundation is actively working to establish comprehensive global sustainability reporting standards. These standards are anticipated to pave the way for greater standardisation. The expected adoption by major financial markets, including in Hong Kong by 2025[11], will enhance sustainability disclosures and thereby providing clearer, more consistent insights from the relevant data, ratings, and indexes.

Furthermore, the Securities and Futures Commission (SFC) of Hong Kong announced in October 2023 its support and sponsorship for the development of a code of conduct for ESG ratings and data products providers. [12] This code, intended for voluntary adoption by ESG ratings and data products providers operating in Hong Kong, will be developed by an industry-led working group of which the Hang Seng Indexes Company is a member. The Voluntary Code of Conduct is designed to strengthen the transparency, quality, and reliability of ESG information.

As a pioneer in creating innovative indexes for the Hong Kong and mainland China markets, the Hang Seng Indexes Company is positioned to collaborate with relevant stakeholders to further enhance the data quality and transparency of sustainability indexes.? By working together, we continue to provide professional sustainability indexes that meet the diverse needs of SWFs and other institutional investors.?

Disclaimer

The information contained herein is for reference only. Hang Seng Indexes Company Limited (‘Hang Seng Indexes’) ensures the accuracy and reliability of the information contained herein to the best of its endeavours. However, Hang Seng Indexes makes no warranty or representation as to the accuracy, completeness or reliability of any of the information contained herein and accepts no liability (whether in tort or contract or otherwise) whatsoever to any person for any damage or loss of any nature arising from or as a result of reliance on any of the contents of this document, or any errors or omissions in its contents and such contents may change from time to time without notice.

The information contained herein does not constitute any express or implied advice or recommendation by Hang Seng Indexes for any investments. Investment involves risks. Prospective investors should seek independent investment advice to ensure that any of their decisions is made with regard to their own investment objectives, financial circumstances and other particular needs. Prospective investors should also note that value of securities and investments can go down as well as up and past performance is not necessarily indicative of future performance.

? Hang Seng Indexes Company Limited 2024. All rights reserved.

[1] Invesco. (2022).?Invesco Global Sovereign Asset Management Study.

[2] Norges Bank Investment Management. (2022).?Responsible investment 2022?(p. 7).

[3] Hang Seng Indexes Company Limited. (2023, July 11).?ESG Insights?(p. 3).

[4] Hang Seng Indexes Company Limited. (2023, October 30).?ESG Insights?(p. 7).

[5] PGGM. (2015).?Responsible investment annual report 2015?(p. 59).

[6] Government Pension Investment Fund. (2017).?ESG report 2017?(p. 7).

[7] Korea Investment Corporation. (2021).?Annual report 2021?(p. 37).

[8] New Zealand Superannuation Fund. (n.d.). NZ Super Fund shifts $2.5 billion to low-carbon indices in sustainability push.

[9] California State Teachers’ Retirement System. (2021-22).?Sustainability report 2021-22?(p. 26).

[10] Office of the New York State Comptroller. (2023, March 31). DiNapoli: NYS Pension Fund Commits $1.3 Billion to Sustainable Investment Program

[11] Hong Kong Exchanges and Clearing Limited. (2023, November 3). UPDATE ON CONSULTATION ON ENHANCEMENT OF CLIMATE DISCLOSURES UNDER ESG FRAMEWORK

[12]Securities and Futures Commission.(2023, October 30).?SFC supports and sponsors the development of an industry-led voluntary code of conduct for ESG ratings and data products providers