Sector Neutrality - An Essential Mechanism Within The S&P 500 ESG Index

Summary

• The S&P 500 ESG Indices aim to achieve a broadly sector-neutral outcome by making ESG score exclusions on a relative basis within each GICS industry group, rather than removing entire industry groups.
• The S&P 500 ESG Index’s performance has consistently benefited from selecting the second-best scoring constituents and avoiding the worst ESG-scoring constituents.
• The S&P 500 ESG Index has successfully provided a measurement of U.S. equities with an ESG lens and has maintained similar industry group weights as the S&P 500.

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By Stephanie Rowton

The S&P 500® ESG Index seeks to provide a measurement of U.S. equities while incorporating ESG factors.¹ The index maintains similar industry weights to the S&P 500 while enhancing the index's sustainability characteristics.

The Importance of Sector Neutrality within the S&P 500 ESG Index

A common misconception is that ESG indices remove or underweight sectors deemed environmentally unfriendly such as Energy or Utilities. Rather than excluding sectors, the S&P 500 ESG Index selects companies that perform highest when considering environmental, social and governance metrics, while historically reflecting many of the attributes of the S&P 500. Removing entire sectors may result in a shift in weight toward other sectors - potentially creating sector bias and concentration risk.

Using Information Technology as an example, one constituent was excluded as per the S&P ESG Indices methodology. It then selected constituents from each industry group within Information Technology, starting from constituents with the highest ESG scores, to reach 75% of the underlying index's market cap. From this, 22 constituents were selected, meaning the index included only 33% of the initial stock count from the S&P 500's Information Technology sector. Were the methodology to reallocate additional weight to Information Technology, it could have created concentration risk in the few selected constituents.

Achieving Sector Neutrality

The S&P 500 ESG Indices aim to achieve a broadly sector-neutral outcome by making ESG score exclusions on a relative basis within each GICS® industry group, rather than removing entire industry groups.² Consequently, the success of the index is not solely measured through its performance, but rather by whether industry group weights (and, by extension, sector weights) remain similar to the S&P 500.

However, excluding companies based on ESG metrics will result in deviation from the underlying index. Some active share is therefore inevitable; while the sector active share is only 6.27%, illustrating broad sector neutrality, the index itself has an active share of 27.54%,³ driven by a disparity in holdings and weights with the S&P 500. The deviation between the S&P 500 ESG Index and the S&P 500 is particularly evident when a sector has several constituents removed or a company with a high float market cap (FMC) is excluded.

When considering Information Technology (see Exhibit 2), it is possible to conclude that active share was likely driven from a few constituents that were included in the S&P 500 ESG Index. Furthermore, Broadcom (AVGO), with an FMC of 1.35%, was not selected for inclusion (see Exhibit 3). Whereas the removal of Amazon, with an FMC of 3.79%, is a likely driver for the deviation in the Consumer Discretionary sector.

Performance Attribution

Perhaps unsurprisingly, performance attribution primarily reveals the history of constituent selection rather than sector weighting (see Exhibit 4).⁵ This is partly because the index has historically been successful in maintaining similar sector weights to the S&P 500. An additional outcome of maintaining similar sector weights is the index achieving relatively low tracking error⁴ at 1.39%.⁶ Interestingly, the S&P 500 ESG Index's performance has consistently benefited from selecting the second-best scoring constituents⁷ and avoiding the worst ESG-scoring constituents.⁸

Conclusion

The S&P 500 ESG Index has successfully provided a measurement of U.S. equities with an ESG lens and has maintained similar industry group weights as the S&P 500. By utilizing index construction to maintain broad sector neutrality, the index has historically reduced the impact of sector-driven performance, increased the impact of stock selection and consequently produced low tracking error versus the S&P 500.

¹ See Rowton, Stephanie, Sanchez, Maria, "The S&P 500 ESG Index: 5 Years of Defining Core Through an ESG Lens"

² See Rowton, Stephanie and Sanchez, Maria, "The S&P 500 ESG Index: 5 Years of Defining Core Through an ESG Lens"

³ Source: Arrow, S&P Global as of June 30, 2024.

⁴ Please refer to the Exclusions file.

⁵ See Rowton, Stephanie, Sanchez Maria "The S&P 500 ESG Index: 5 Years of Defining Core Through an ESG Lens"

⁶ Data as of April 30, 2024, 36-month annualized tracking error.

⁷ New Frontiers: The S&P 500 ESG Index's Performance Beyond the S&P 500

⁸ See Beyhan, Maya, "The Key to the S&P 500 ESG Index's Outperformance: Avoiding the "Worst"

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