ESG integration in passive strategies. The most common purpose of passive equity investing is to achieve performance, risk, and return that matches, or is very close to that of a chosen benchmark index. It involves the design of a set of techniques and processes that either replicate the index or take on exposures that are similar to an index. Importantly, passive investing does not involve sector or individual security analysis or investment decisions. Instead, it uses a rules-based approach. How can ESG integration be incorporated into passive investing? Well, the simplest way to do this is to use a negative screen, a list of exclusions, and design a portfolio similar to the benchmark, yet one that does not hold those stocks that appear in the exclusions list. The exclusion could be applied to companies that achieve low ESG scores, or it could be applied to those that are involved in an activity that is deemed to be unacceptable from an ESG perspective. For example, the exclusions could be applied to companies involved in gambling or distribution or production of alcohol. Applying such a set of exclusions mean that we construct a portfolio that complies with our choice of ESG criteria. But the drawback is that portfolios constructed by excluding certain companies or sectors will inevitably have risk and return characteristics, markets and factor exposures that differ from those of the benchmark. Reducing or eliminating exposure to certain sectors represents a natural reweight to the remaining sectors and index constituents. Examples of exclusion-oriented strategies include approaches that target minimized exposures to fossil fuel. That can be done by excluding carbon emission and greenhouse gas intensive industries. Alternatively, one can comply a carbon emissions cap relative to the main index. More sophisticated approaches provide investors with a passive means to weight an index towards a star act of their choice, whilst also screening for companies that perform better on ESG metrics. The resulting portfolio will be highly dependent on the screening methodology and the ESG dataset used. Index providers now offer a very wide range of indices that weight constituents using different degrees of ESG metrics. They users can then design portfolios that replicate the performance of such benchmarks, or in a more active fashion, may try to design funds that beat the performance of such benchmarks. If sufficient data is available, any portfolio's ESG metrics such as overall ESG scores or carbon intensity can be compared to the indices' ESG scores. Index providers such as FTSE Russell or MSCI have significantly widened their offering of indices, particularly those in the ESG space. These indices can be used as benchmarks for fund managers to be measured against, or as model funds for investors to directly invest in as a form of passive management. The growth of the passive ESG strategies is driven by demand and is possible thanks to better availability of larger data sets of ESG metrics for individual companies. The indices rely on rules-based criteria assessed on underlying scores or metrics. The criteria then go into a formula to tilt company weightings or exclude entire companies based on ESG scores or hurdles. The scores are usually sourced from ESG ratings providers such as SUSTAINALYTICS or MSCI ratings. Investors using such indices or requiring their fund managers to use such indices as benchmarks must bear in mind that although their ESG preferences can be satisfied using these strategies, the performance achieved in terms of risk and return is likely to deviate from that of the underlying unadjusted ESG agnostic benchmark that usually reflects the behavior of the market as a whole.

Constructing and using ESG indices presents a number of challenges and risks. Compared to data used for the construction of established benchmarks, ESG data is less well established in terms of terminology and consistency. ESG data also has limited history and regional breadth. This matters because it makes comparisons difficult. It also makes it difficult to assess past performance of such indices. ESG disclosure remains largely voluntary, with limited global convergence, making the methodology behind a passive ESG strategy highly individualistic and interpretive. Another issue that may arise when constructing benchmarks that exclude particular sectors or groups of companies is that this method may limit one's ability to diversify.