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Why Using An ESG Filter Helps Prevent Stock Market Shocks

ESG assessment by institutional investors can go beyond ticking the box, desk research, evaluation of historical episodes of treatment of minority shareholders and asking the management tough governance questions.

As a way to incorporate governance, are ESG indices a viable alternative? Many traditional ESG index construction approaches typically sort a universe of stocks using the companies' ESG scores, eliminating those with the worst rankings, and cap-weighting the remaining.

This does not render them true to mandate as ESG is just a filter mechanism, and portfolio weighing is determined by market cap and not ESG. A low-rated ESG company, which just meets the threshold, can have outsized weights in the index due to its size.

Thus, till better regulations bring in greater transparency, standardisation of disclosures and quality ESG actions, as well as accurately constructed ESG indices, investors would do well to trust an active ESG fund to account for the fact that what you see is often not what you get.

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