Sustainable index funds

A blueprint

The fact that sustainable investing (also known as ESG investing) has taken off is now common knowledge. 2020 was a historic year for sustainable funds: the money flows to sustainable investment funds increased by 88%, with Europe clearly serving as the key driver; it invested almost 80% of the €125 billion that was invested in these funds.

These flows fit well with the trend line of growth in assets under management in European sustainable funds, which are steadily rising year on year. The number of sustainable ETFs also shows that more funds are being launched year on year and that assets under management were again at an all-time high in 2020.

Global Sustainable Fund Launches

Groei Europese duurzame fondsen
Source: Morningstar Direct, Morningstar Research, as per September 2020

Record-Setting 2020 for ESG ETFs

Recordaantal ESG ETF’s in 2020

Nevertheless, opinions on investment policy and views of what constitutes passive sustainable investing vary fairly widely. This is tricky, given that the essence of passive investing is to keep the broad market in the portfolio, or at least a selection of shares that are a good representation of the broad market with enough diversification. It is therefore important to define what sustainable index investing is and what it should look like. A crucial point is to stay close to the essence of passive investing and to simultaneously apply a sustainable investment policy that should not detract from the ultimate objective, i.e. a return that should be very close to the returns from the broad market. A blueprint for this can be broken down into three topics:

  1. an active ESG policy;
  2. pursuing a pure ESG effect; and
  3. the objective of investing in the broad market.


When implementing an ESG strategy, voting and engagement should undoubtedly be brought back into play. These tools have long been central to the implementation of a sustainability policy, but they are now actually already considered a given in a passive investment strategy. This is also clearly visible in communications from the world's largest asset which, following criticism from the market and various stakeholders, has become increasingly active in this area in recent years. The fact that a sustainable index investor votes and has an engagement programme will, therefore, no longer be seen as a distinguishing factor. Nevertheless, the use of these tools remains very important: voting and engagement allow shareholders to adjust a company's direction and raise issues which they feel could be improved on.
An active ESG policy will also mean exclusions. And this is exactly where a passively managed sustainable investment fund should distinguish itself from a fund with an active ESG policy. The reason is that the world is not static in which companies operate, nor are the actions and policies of these companies; in fact, they are dynamic. Exclusion on ethical grounds is no longer enough for a sustainable passive investment strategy. With initiatives such as the EU taxonomy, sustainable index funds will need to go through their holdings with a fine-toothed comb to see if they meet the requirements of this taxonomy. Investors who want their portfolios to qualify for an eco-label (i.e. a green label issued by the EU) will need to include a percentage of companies (yet to be determined) with green activities. The taxonomy states that if these activities meet one or more of the six environmental objectives, they may be classified as green. These objectives are:

  • Mitigating climate change
  • Adapting to climate change
  • Protecting marine and water resources
  • Transitioning to a circular economy
  • Preventing pollution
  • Protecting or restoring biodiversity and ecosystems ecosystemen

To meet the requirements, a sustainable benchmark can be chosen. The benchmark provider will then already have done the filtering for the asset manager or asset owner; the fund follows this benchmark. The problem here, however, is the somewhat static implementation of corporate screening. Most benchmarks update the benchmark once, twice or four times a year, but in the intervening periods the companies remain part of the benchmark.

But what if, during that intervening period, it becomes apparent that a specific company is not doing as well as everyone thought? This means that, as an index investor, you are dependent on the benchmark provider's exclusion policy and process, so you have to follow the benchmark provider's update. There is a case for saying that this is illustrative/symptomatic of passive management, but in the meantime index investors still want to invest immediately and exclusively in truly sustainable companies that meet ethical standards and sustainable investment beliefs and not in companies that got really bad news coverage some time ago.

The worst-case scenario is that the relevant company is not removed from the benchmark until six months after the fact; until then, it is still labelled ‘sustainable’. A well-known example is “Dieselgate”; Volkswagen did not disappear from the benchmark until a full quarter had passed (for some benchmarks this even took six months).

There is also the problem of being dependent on the benchmark provider's policy. Some exclusion policies are questionable. For example, if you follow the Dow Jones Sustainability World Index benchmark, you will still be investing in tobacco; a sector that you would not necessarily associate with sustainability. On top of that, we must ask ourselves whether a benchmark provider's policy is comprehensive and/or in line with the investors' requirements. In recent years, a lot of time and energy has been spent on the “green side” of companies (both companies that are doing well in that regard and those that are not).

But if that is a benchmark provider’s basic criterion, then a lot of essential sustainability issues may be underexposed or even ignored. Indeed, the social and governance aspects of sustainable investing are equally important. These two components are now mostly addressed on an ad hoc basis in response to incidents, while the climate is regarded as a global problem that is now being raised and addressed by companies and governments alike.


When an index fund implements a sustainable policy, it should consider the inherent consequences of implementing an exclusion policy as well, because ESG policies will ultimately have an effect on the final components of the portfolio. As a result, a passive strategy may give an underlying overweighting to certain factors compared to the broad market. These factors may be sectors, for example, but also value and growth. Such deviations compared to the broad market cause those components to deviate from the broad market as well. This, in turn, may also cause return differences to deviate from the broad market, which passive investors should not be willing to accept. Opting for an ESG benchmark as a proxy for the broad market does not solve this problem either. In fact, the differences compared to the actual real broad market remain.

Sector breakdown MSCI indices

Sector breakdown MSCI indices
Source: MSCI

It is too simplistic a solution to opt for a benchmark which already incorporates exclusions and other criteria. That's where the ESG benchmark and the actual broad market will then diverge. Therefore, the broad market should be represented by the broad benchmark since, ultimately, that defines the essence of index investing. Thus, the discrepancies between an ESG benchmark and the broad benchmark lead to opting for the ESG benchmark being an active choice instead of a passive one. Looking at ESG benchmarks, it becomes clear that growth-oriented sectors are more overweighted than value-oriented sectors. Technology is more often overweighted than financial and oil shares. That does not necessarily have implications if the underlying factors that help determine the return are close to the broad index. An underweight in oil is not actually that odd for a sustainable investment strategy.

However, this is not always the case with an ESG benchmark. Consider for example the MSCI Paris Aligned benchmark or the MSCI SRI benchmark: in both cases there is factor deviation between the ESG benchmark and the global broad index. Even though the results may not be very pronounced, in the end the difference does affect the final return.

MSCI World Climate Paris Aligned - Key exposures that drive risk and return

MSCI World Climate Paris Aligned
Source: MSCI

MSCI World SRI - Key exposures that drive risk and return

Source: MSCI

In implementing an ESG policy, the focus should be on a pure ESG effect. This means that the idiosyncratic ESG risk of companies that are excluded, underweighted or overweighted are taken into account in determining the strategy profile. The ultimate goal of an exclusion policy is to ensure that you do not own shares with certain undesirable characteristics or activities. That is the only factor you want to take into account in the return profile.

As a passive investor, you do not seek to add any other effects to the portfolio. Other style effects such as an extreme overweighting in growth shares (because a lot of oil and gas companies are in the value segment) should have no or only a minimal impact on a sustainable passive strategy’s return profile. The same applies for sector or country deviations where you want to avoid being underweighted in consumer goods by excluding tobacco.


For a true passive investor, the definition of the broad market is the global stock market. A deviation from that market is already an active choice. However, you may decide to do so when, for example, you are aiming to build up exposure in a particular sector. Sector indices are available for this. The underlying idea is that there should be a vision of future returns in these sectors. That vision and acting on it is an active choice and may have more to do with active rather than passive investing.

With the rise of sustainable passively managed investment funds, funds are being launched that frame sustainability very narrowly. That is, they select a small subset to invest in. Active choices are made for each chosen benchmark that deviates from the broad market. One glaring example of this from the past year is the S&P clean energy index. This index had a return that was 115% higher than that of the MSCI ACWI. Investing in this is an incredibly active choice. Although this example is extreme, it emphasises that every choice for a benchmark is an active one. The more the benchmark provider filters and compiles, the more active the choice of benchmark becomes. That said, choosing a broad market index as the benchmark and implementing an active ESG policy also counts as active investing based on conscious choices. This avoids (the appearance of) passivity when tracking an ESG benchmark. Both options are explainable and valid. However, currently sentiment seems to suggest that when an ESG benchmark is chosen and fully replicated, this is no longer an active choice. After all, this means that the definition of the broad market has been modified which means that the investment policy is passive. However, implementing an active ESG policy which seeks to minimise deviations from the broad market should be classified as a passive investment policy. Whether this is done using an ESG benchmark, a customised benchmark or a broad market index where the tracking error is minimised, the aim of passive investing is and will remain to approximate the return/risk profile of the broad market as much as possible. Thus, this does not mean that the definition of the broad market is adjusted in order to remain compliant with passive investing rules, where deviations from the broad market are not or only partially considered.


Sustainable index investing is on the rise, and there are many ways to go about it. However, we believe that we should keep to the essence of passive investing. Sustainable investing should, in any case, include an active EGS policy. However, an ESG benchmark is not the be-all and end-all; the initial filtering may align with the investment policy but intermediate changes are not implemented at all or are implemented late. It will also be necessary to consider the style effects of a passive strategy. The broad benchmark should be taken into consideration and the effects of any exclusions should be neutralised as much as possible, matching the risk/return profile of the broad market as closely as possible. There also is an appearance of passivity when following an ESG benchmark, since such benchmarks also deviate from the broad market. Deviating from the broad benchmark does not necessarily mean that there is active management. Active management involves a vision of the market; pursuing the risk/return profile of the benchmark does not correspond to a vision. This means that there should be awareness, on the part of investors and their choice of funds or benchmarks, that implementation choices do not fully match the goals of investors who want to invest their money sustainably and passively.

The essence of passive investing is not captured when an overly narrow ESG index is chosen. The implementation of exclusions and how frequently they are updated are important as well. And then there is the passivity in the return/risk profile of a sustainable index fund which should reflect the profile of the broad market as much as possible. Therefore, it is important to weigh up the trade-offs against the implications (and thus ESG benchmark tracking with a 0% tracking error is not passive management).

What if we then consider an EU taxonomy-aligned benchmark? Then a fund does get labelled as a sustainable fund, doesn’t it? The answer to this is yes, formally speaking. The same three concerns, (an active ESG policy, the pursuit of a purely ESG effect and the objective of investing in the broad market) align with an EU taxonomy-aligned benchmark. On top of that, however, an EU taxonomy-aligned benchmark will only focus on what the EU taxonomy prescribes and to date, that only covers the E (environmental) within ESG. Governance and social factors (the S and the G) will also need to play a role. Only then will the world become more sustainable in the broadest sense.