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Indices - Carporate Sustainability and Financial Indexes 58...

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Unformatted text preview: Carporate Sustainability and Financial Indexes 58 Sustainability and Financial Indexes Alois Flatz‘ W Introduction investors increasingly see forward- looking nontinancial metrics as key to understanding a company's true value, while stakeholders demand ever greater transparency from multinationals on how they are managing their responsibilities to society at large and the environment. These trends are manifested in the increasing impact sus- tainability is having on mainstream investors, as illustrated by the following: - Since its launch in 1999, the Dow Jones Sustainability World Index (DISK World)2 has benchmarked the per- formance of the world‘s leading sustainability compa- nies, enabling investors to track and adapt their products along sustainable guidelines. As of August 2001, 33 licensees have created financial products based on the D151 World, with total assets under management amounting to more than 2.2 billion Euro. These investors are offering sustainability-driven mutual funds, equity baskets, certificates, and segregated accounts. - Diner leading organizations on boat sides of the Atlantic have also been involved in supplying investment com- munity with indexes around this theme. For example, since 1990, KLD (KinderLydenbergDomini) has man- aged the Domini 400 Social index5 with particular empha~ sis on the societal contribution of North American companies. Moreover, in July 2001, UK-based index previder FTSE (Financial Times Stock Exchange) launched the F'l'SE4Good‘ series of indexes to provide a benchmark to the SR1 (Socially Responsible investment) community. - Recent legislative changes in Europe and Australia have also confirmed the trend toward incorporating sustainability criteria in investment decision-making. For example, both the UK5 and Germany“ have passed laws obliging pension funds to disclose their investment policy with regard to environmental and social criteria. In August 2001, Australia’s Senate’ passed an amendment to the Financial Services Reform Bill to require super funds and investment managers to disclose their policy on ethi- cal invesrment. - Significantly, the Swiss Federal Social Security Fund awarded State Street Global Advisers, the investment management arm of State Street Corporation, a 320 million Euro global equity index mandate based on the DJ Si World in May 2001, the largest mandate of its kind.“ Previously, and despite high demand, the investment commu- nity was unable to rely on credible socioenvironmental data on which to base microeconomic decisions clue to lack of avail- ability of relevant data. Now, the ability to make macroeco- nomic decisions around socioenvironmental issues, which has been possible for many years, is complemented by a new abil- ity to make associated microeconomic decisions due to recent developments in data provision around sustainability. This paper outlines the challenges in assessing the sustain- ability performance of the world’s largest companies and integrating the results into an index tracking the financial performance of leading companies. Following a definition of corporate sustainability, we focus on exploring the character— - istics of traditional indexes and what implications these have on the challenge of indexing the performance of companies that embrace sustainability. Subsequently, we describe the process for developing the Dow Jones Sustainability World Index (DJSI World) as an introduction to the issue of how the specific challenges of assessing corporate sustainability have been addressed, with particular focus on the implications for indexes tracking the stock market performance of companies embracing sustainability. Finally. the risk and performance attributes of the D181 World are explored to determine the value and validity of tracking the performance of corporate sustainability leaders in general. 127 Table 1 Sustainability Driving Forces _ Ecological Forces Sociocultural Forces Economic Forces 128 Global transparency in society through media and technological connectivitycorporate behavior is product cycles. business relationships. and clear for all the world to see competition Inc: easing ecological degradation with nega— Divergent demographic trends in developed and Continuous scientific and technological rive impact on human health and quality 01 life less—developed regions progress W loss at ecosystems and biodiversity - ‘ Wide social imbalances and inequalities in dental Information is ltey factor oped and less-developed regions (income, poverty, human rights. etc.) lncreasing speed-embracing innovation and bilities Lower capacity at natural sinlrs as carrying capacity is decreasing lsoil. water, lorests. etc.) Urbanization and urban lifestyles Technological connectivity and virtualization of lbusinessl relationships Scarcity of water in terms of both quality and New lilestvles of sell-organized groups with Globalization and liberalization ol economic volume shared values activities m Consumer behavior changing due to awareness ol Increasing power ol multinational businesses inequalities. social imbalances. human rights, and compared to national states unfulfilled development potential Consumer behavEOr changing due to awareness of Shilt horn supply-side to demand-side mar- ecological changes and social instabilities Rats W Healthy living as an important part of individual lifestyles W __ ,i,~————QL*_.__H_T____M Definition of Corporate Sustainability One of the early attempts to define sustainability was pre- sented by the Brundtland Commission’ at the United Nations General Assembly in 1987: “Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs” (World Commission on Environment and Development, 1987). If one considers businesses as living organisms, the need to behave in a way that avoids compromising societal and eco- logical systems is clear. Not compromising their ecological. societal, and economic environment in a wider sense is of vital interest to a company. As the environment in which eco- nomic activities are embedded becomes more unpredictable and fragile, higher-risk premiums are paid for increased volatility and uncertainty. Highly efficient economic systems (to ensure efficient resource allocation) require predictabili- ty and cannot afford to spend great resources on stabilizing the systems of the wider environment (for example, financ— ing safety measures or remediation). Sustainability on a long-term basis requires businesses to satisfy the needs of their clients in a way that their products and the organization of their services (the value chain) follow the dynamic sys- tems rules of ecological and sociocultural systems. Since societal. cultural, and ecological systems are not stable. their dynamic balances are in a state of permanent change. Thus, businesses survive, not by maintaining a static busi- ness model, but by propagating their species, thereby indi- cating that sustainable business must be a dynamic state. Consistently reinventing a company in line with market, societal, and environmental realities and changes to ensure its own sustainability has proved the key to longevity and profitability of businesses (de Geus and Songs, 1997). The challenge of enabling sustainable economic growth, in the broad sense, offers new Opportunities for companies to enhance their shareholder value by aligning with the emer- gent realities of the environment in which they operate. In line with this philosophy, corporate sustainabilicv can be defined as: a business approach to create long-rem: shareholder value by embracing opportunities and managing risks deriving from economic, ecological and social devel— opments or changes. These economic. ecological, and social developments. or changes are trends that need to be considered and managed effectively, by maximizing the opportunities and minimizing the risks they present. if a company is to contribute to a sus- tainable future for itself and the parts of the systems in which the business is embedded, While a full discussion of these forces is beyond the scope of this paper, a summarized list of trends is illustrated in Table 3. Corporate Sustainability and Financial lndeves - CI 'Id . 2m. lI~ rm 1m: I I'llti‘.rlili' t-mbtamr'ig sustainabilil} increasing awareness of the trends higinipimv q. enhanCes the importance of a company‘s managrimnt m. in m n.:.. mime iltt'n ppm-sung: risks and, thereby, lower these developments. Companies that understand how thesi- tin-n t‘qtnI) costs. It pl't'sm'riuhl} would also result in lower forces offer opportunities to enhance shareholder value, 0r Inn-rowing costs, leading to [HWt'l rush: of capital, and, again, pose risks to shareholder value, and adjust their corporate to higher ROE. Lower htu‘tiiwtng‘ costs may alsobe the result Corporate Sustainability ano rmaneiai llluaAUa 3 l . strategies and operational procedures accordingly, are on the roadto achitwing corporate sustainability. Probably one of the most important driving forces is the dramatic increase in transparency, caused by global media and connectivity. in turn, this increases the importance of brand integrity and the ' need to develop trust among all stakeholders. Using Corporate Sustainability in the Investment Community An index tracldng the performance of companies addressing sustainability is valuable when it provides insight into the future financial prospects of a company or industry that con- ventional analysts are unlikely to incorporate, given a lack of focus on the potential for certain social, environmental, and economic issues in society to materialize and affect companies. As traditional valuation metrics and historical corporate information increasingly concede importance to future- oriented, forward-looking indicators of the health of a com- pany and its attractiveness to an investor, indexing the performance of companies addressing sustainability attempts to provide investors with the insights they are increasingly seeking (Funk, 2001). Thus, as an investment insight, equity research in relation to sustainability must be: - forward—looking; - based on industry-specific value drivers (as opposed to generic data); - transparent and easily understood; and - capable of adding value to existing valuation methods. Assessing corporate sustainability aims to incorporate the char- acteristics mentioned above and ofiers insight across most equi- ty asset classes and investment styles. The hypothesis for the business case for susrainability interpreted as a portfolio of stocks is that these stocks will be expected to outperform com- parable portfolios, at least in the long run. The reasoning for this expectation is sound. Companies embracing global sustainabil- ity trends are likely to achieve a higher return on equity (ROE) andlor a lower required rate of nean (RRR) than companies that ignore these trends. Higher ROE may result from a better understanding of investment opportunities or from lower non- operating cost, because of a better understanding of risks. Higher ROE may also result from social pressure groups chan- nte rig demand into sustainable products. A lower RRR may result from a better understanding and management of risks. The ERR is a function of operate of investors considering other parameters than just risk and return. High ROE and low Rth result in free cash flow that can be invested profitably when embracing sustainability trends. A portfolio, or an index composed of this type of company, thus will appreciate faster than a portfolio or an index of companies not embracing theoretically profitable investment opportunities. Investments in companies embrac- ing sustainability thus promise higher returns and, due to lower business risk, better risk—return ratios. Based on this hypothesis, better performance can also be expected on a risk-adjusted basis. Index Characteristics 8: Challenges for Sustainability Characteristics of an Index Security market indexes, or, more generally, security market indicator series, are designed to reflect valuation and changes in the valuation of a specific universe of securities (Reilly and Brown, 1997). They are intended to represent a universe or population of securities. Movements of the index's perfor- mance are supposed to allow inference to movements in the performance of the securities in the underlying universe. The univerSe targeted, together with the purpose of the indicator, deter-mines which factors need to be considered in designing I the index. Sample size, sampling method, and the weighting scheme are prominent examples of design elements. l The targeted universe can cover as much as the broad domes- i tic economy or as little as some subset of a particular niche security market. The DJSl reflects changes in valuation of a universe of companies that are leaders in terms of corporate sustainability. The universe of companies embracing sustain- ? ability is broader than the D] S], but the DJ SI comprises the : leadem in corporate sustainability, as judged by industry. Thus, the D15] not only traces, but also implies, a universe of leading companies with regard to addressing sustainability. Indexes are based on statistical information and calculation and, in general, have the following characteristics” - accurate and reliable data; - clear. transparent, and replicable methodology; - rules-based processes; objective and bias-free; and component data freely available. An index tracking the performance of corporate sustainability leaders must have all the show—mentioned characteristics of a 129 I'Jn traditional index. In addition, it must be flexible enough to meet changing indexing trends and investor demands, such as the demand for broader benchmarks. Challenges for an Index Tracking Corporate Sustainability Overrecent years, increasing numbers of investors have been aligning their investment strategies along sustainability crite— : ria. This growing number of new financial products integrat- ing sustainability in their core investment strategy provided the impetus for a neutral, rigorous, transparent, and easily replicable measurement of corporate sustainability. The chal» lenge facing the indexing industry has been how to measure and quantify corporate sustainability, and how to integrate the results into an investable index that meets the needs of the investment industry. By incorporating this type of equity research into an index, i . very specific new challenges arise——narnely, and in no par- ticular order: Development of relevant assessment criteria (generic and industry—specific) An indexrtrackirtg the performance of corporate sustainabil- ity leaders first needs to define corporate sustainability and relevant assessment criteria- Criteria representing the chal- lenges deriving from sustainability trends have to be devel- oped and quantified in such a way that the best-positioned companies can be measured and identified. Gathering of corporate information An important challenge is how to gather the correct and rel, evant information to measure economic, environmental, and soeial performance dimensions. While some global compa- nies publish corporate sustainability reports, the majority of companies are only beginning to understand and, hence. report on the concept of corporate sustainability. More important, not all data are c0nsistent, relevant, or compara— ble. Quantification of corporate sustainability A key challenge in developing an index tracking corporate sustainability is how to quantify corporate sustainability. in most cases, sustainability developments are qualitative in nature, so they may lack easy quantification. While assessing companies’ environmental performance and emission targets seems relatively straightforward, a consistent and equally quantifiable method is not readily available for many aspects of social and economic developments. Identification ofsttsmt'nabt'lit)= lenders in each industry group Given that sustainability trends affect each industry differ- ently inciting-specific challenges arise. As a result, industr} leaders need to be identified for each industry group, known as a “best-in-class” approach. Sustainability leaders within each industry group need to be ranked according to their core porate sustainability performance relative to one another. Individual industry groups should not be excluded based on the perceived sustainability of the particular sector. Constructing an index with appropriate selection rules A further challenge is how to construct the index. While most indexes represent a group of stocks with a specific goal, it is imperative to define clear selection rules reflecting the pauticu- lar focus of the specific index. The number of companies con- sidered corporate sustainability leaders and how their stuck should be weighted is the critical consideration and challenge when selecting final components. When identifying leaders for each industry group, minimum sustainability standards need to be set to clarify at what threshold a company should no longer be considered a sustainability leader. Fulfilling traditional index requirements A corporate sustainability index needs to fulfill all the char— acteristics of a traditional index—it should be accurate, reli- able, transparent, and consistent. The Dow Jones Sustainability Indexes," a collaboration of Dow Jones Indexes and Sustainable Asset Management (SAM), were developed as a response to these needs and chal- lenges and, since its launch in 1999, have grown in number of licensees and assets under management. The next section of this paper explores the process used to develop the DIS} World as an example of how these challenges are being met. Construction of the Dow Jones Sustainability Index The index construction process of the Dow Jones Sustainability World Index (DlSl World) provides a good introduction to how index providers address the challenge to produce indexes tracking the financial performance of sus— tainability leaders. A description of the general challenges and how these were solved in the most important process steps of the D181 World is described below (with the excep— tion of the assessment step, which is deseribed in detail in the next section)” lnvestable Universe and industry Allocations In determining the initial investablc universe from which the final components of the index are selected, key issues to con— sider arc the core purposa of the index, what the index should represent, the acceptable level of liquidity of the stocks, the acceptable level of tradability, and the optimal level of con— vergencc of the currencies represented. The Dow Jones World index of the 2,500 largest companies in market capitalization. of the total universe of more than 5.000 companies, is used as Figure 1 —___________..___-———-—-*—’_+—_( Overview of DJSI Construction Process Dow Jones Sustainability Indexes Amer-hone! Dorm emu. stout rm. and 5AM G-ouu Index Construction Process lmrestable Universe I Allocation to Industry Groups l Corporate Sustainability Assessment I Ranking within industry Groups Index Component Selection Index Calculation I Ongoing Review a basis for the DJ 51 World investable universe. The targeted universe can cover as much as the broad domestic economy or as little as some subset of some niche security market. A further critical step is determining the allocation of indus— try groups for the investable universe. The homogeneity of the stocks allocated to each industry group must be fairly high because dependence on similar sustainability trends allows comparison among the relative performance of indus- try components, which are based on the 64 industry groups of the DJSI World. Component Selection Several challenges exist in the actual construction process. Regarding the ideal number of index components, the purpose of the index must be addressed. Decisions must be made about whether the index should provide an investment universe and benchmark for active asset managers or the direct basis for a financial product (such as an investment certificate). An active asset manager usually prefers to have a wide investment uni- verse to have the possibility of choice in stock selections; however, a passive investor prefers a smaller universe to keep transaction costs low (for example, about 30 stocks for a cer— tificate). Moreover, the number of components has a major impact on the risk attribution of the index as a whole and depends on the overall susrainability score of companies that surpass a 0 minimum threshold of quality, the exact percentage of which is determined by specific assessor approaches. The DIS] decided to provide both a benchmark and an investment uni- verse (DJSI in 2001—2002 contains approximately 300 com— ponents). Setting the right threshold distinguishing the best-positioned companies from the others, and setting minimum standards to be applied should the overall level of quality within an industry be poor, is also a critical consideration regarding component selection. The threshold depends on the number of comporients needed per industry grouping because the “best-in—class" approach is not always applicable, given that there are industries in which few companies react to sustain- ability trends. Component selection can be based on one of three possible approaches: market capitalization, numeric, or a mixture of both. Selection based on market capitalization has the major disadvantage of possibly being dominated by a single com- pany with a very high market capitalization. Should the top- ranked company in terms of sustainability have a high market capitalization, no other companies embracing sustainability in that industry sector could qualify because the allocation of allowable market capitalization will already have been taken up by very highly capitalized stocks. Selection based on the numeric approach would, for exam- ple, select the top 10 percent of companies based on the num- ber of companies in the specific industry group. This method would select 250 companies from an industry group com- prising 2,500 companies. This approach has the disadvantage of often not providing an ideal asset allocation per sector and, hence, a possibly limited risk spread. Therefore, the DJ 51 World pursues a mixed approach incor- porating both numeric and market capitalization-weighted elements,“ which allows for a good representation of an industry’s market capitalization while also assuring that the leading sustainability companies are included. A further Step in the selection of components is how the selected components should be weighted. With regard to traditional indexes, three methods are used to weight the components within indexes: - market value-weighted (for example, NYSE Composite Index, Standard & Poet’s 500 Index, Nasdaq Composite Index, Wilshire 5,000, LondOn FTSE, MSCI indexes); - price-weighted (for example, Dow Jones Industrial Average, BAX 100); and - equal-weighted. 131 132 Regional and sector allocation= currencies, and the method or" stock weightings need to be similar. In the case of the DlSl World, free-float price—weighted market capitalization was selected to reflect the DJGl‘s move to a similar basis. In the next section, we examine how the D181 World specif- ically addresses the challenges to assessing corporate sus- tainability and to developing an index to track the performance of companies addressing this issue. Challenges of Measuring {Assessing} Corporate Sustainability and Developing an index The assessment of corporate sustainability performance forms the basis for an index tracking the performance of companies embracing sustainability. In this section, four spe- cific challenges of corporate sustainability assessment are addressed: 0 defining corporate sustainability criteria; - gathering corporate sustainability information; - quantifying corporate sustainability assessment results; and 0 meeting requirements of traditional indexes. Defining Corporate Sustainability Criteria Selecting relevant and quantifiable criteria to assess corpo- rate sustainability is a major challenge because the quality of the index components depends heavily or: this aspect of the assessment process. Assessment criteria should be easy to measure. understandable, clear, and precise. Corporate sus— tainability is widely based on qualitative criteria, so the most significant challenge is to develop quantitative proxies for qualitative data and integrate these into a system that meets the major requirements of indexing (for example, the need for replicability and objectivity). However, even quantitative data can be difficult to access for many reasons. First, as there are no sta‘ndards for Sustainabili- ty accounting (of environmental and sociocultural issues) and no legal obligation for accounting along these issues, data are not readily available. Second, accessing and comparing com- panies based on environmental and social information is diffr- cult because companies are active in very different business lines even if they are considered to be pan of the same indus- try group (for example, IBM and Deli are not comparable). Third. system borders may be defined differently by different companies because most use production sites as system bor- ders. although some may include transport and storage sites as we‘d. The only viable approach to defining corporate borders. therefore. would be to consider the wit-ole life cycle of a prod- uct. Flo-never. companies Often do nc: have the data since they dz not control the whole value chain. Fourth, there are no spe- ciiic clear indicators from the investment community, and only very divergent standards for normalization and categorization (such as aggregating emissions according to global warming potential). Finally, many companies simply do not have any data to report on many of the issues that corporate sustainabil- ity assessments must cover, and when they do. there is very lit- tle hisrorical information. in the case of qualitative criteria, integration of qualitative issues into criteria with precisely defined parameters (for example, closed—end or multiple-choice questions to which a score is attributed) is the approach used in most assessment methodologies. However, a major challenge is defining the Criteria parameters. For example, how many environmental policies/charters are considered the ideal number to be signed—two, five, or ten—when the real issue is the quality _ of the implementation of these charters? Moreover, maintaining relevance of the criteria is another important challenge. Trends and industry challenges are in constant flux, which means that criteria must be updated consrantly. For the DIS] World, assessment criteria are updated annually to keep them relevant. Furthermore, crite— ria should represent not only challenges deriving from glob- al trends, but also regional challenges where possible. SAM’s approach is based on the hypothesis that large-cap companies face similar challenges based on global social, environmental, and economic trends. The same rigorous approach applied worldwide for the DIS] World allows for clear comparisons despite geographic spread, and worldwide relevance of criteria. Given the wide range of sustainability trends and driving forces, criteria must be selected geared to distinguish between sustainability leaders and laggards. In addition, cri- teria need to be interdependent to represent the systemic nature of companies. Studies have shown that companies that are leaders in one criterion are usually leaders in others as well." Therefore, it is imponant to select the right criteria, rather than a wide range of various unrelated criteria. Table 2 provides an overview of the criteria used in the SAM Corporate Sustainability Assessment. which forms the basis for the D181 World. This approach has been developed with the intention of addressing the challenges indicated above. in addition. criteria are derived from the sustainability trends highlighted in earlier sections and focus on factors such as industry value drivers and success. factors in relation to man» aging the challenges of a changing environment. Each criteri- On listed is divided further into su'ocmeria that are not listed. in essence. assessing a company by specific criteria incorpo- "h rates evaluation 0 a number of issues. specifically: 71 l i Wt, Corporate Sustainability and Financial indexes 72 I exposure of a company to a specific criterion (the challenge the company faces with regard to particular criterion}; I the company‘s policies and strategies to come: specific criteria; - the management systems to implement policyr'straregy; I internal review processes to check progress in relation to specific criteria; and I a company’s track record—both quantitative (if released) and qualitative (documents, interviews, media, and stairc- holders. I Criteria used in the DIS] World corporate sustainability assess- ment are reviewed annually, and external experts are asked to provide insight and recommendations to improve criteria and the entire assessment methodology. Moreover, efiorts such as the Global Reporting Initiative are taken into account to ensure that the criteria used are fully aligned with efforts to standard- ize corporate sustainability reporting and assessment. Gathering Corporate Sustainability Information Standards for corporate sustainability assessment and report- ing, unlike financial reporting and analysis, have not been defined or standardized so new methods to gather relevant and applicable information have to be created. Many sources of information exist, including company reperts, question- naires, industry studies, interviews with companies, third- party opinions (stakeholder inputs), and various media. Some sources are used to access basic information and insight; oth- ers are used to check the validity and truthfulness of compa— ny responses to questionnaires and interviews. Because companies have differing interpretations of how to report sustainability performance, many environmental, social, andlor sustainability rating agencies have created questionnaires to fill this void. However, people may read and understand questions in an assessment questionnaire dif- ferently because of language barriers, lack of guidelines, or Table 2 ._ _____...___——-—--—- SAM Corporate Sustainability Assessment Criteria Opportunities Risks Economic 0 Strategic and financial planning I Corporate governance I Organizational development I intellectual capital management O IT management and IT integration I Quality management I Customer relationship management I Branding and brand management I Reporting and acupuoting industry specific [for example} I 8&0 programs 0 Risk and crisis management I Compliance systems I Corporate codes at conduct lndustry specific (for example] I Specific risk management iSSues / Environmental I Environmental charters - Responsible person ior environmental issues I Environmental, health, and salety reporting industry specific {for example} O Eco-efficient products and services lincluding strategy, 8&0} I Environmental policy and lmeglallOT‘l into overall strategy e Environmental management systems I Environmental input and output periorrnance I Environmental profit and loss accounting industry specific [for example} I Hazardous substances I Environmental liabilities If/fl—‘f— Social I Social policy and integration into overall strategy I Responsible person for social issues I Stakeholder involvemerr. 0 Social reporting I EmplOyee boneiirs I Employee satisfaction I Remuneration systems Industry Specific do: stamp-is, ICGmrnunriy programs - Conflict resolution I Equal rights and nondiscrimination * Occupational health and saiety Standards I Freedom of employee organization I Standards for suppliers industry specific ilot exarripls: I Personnel training in developing countries d______r_______________._______—————4———— 133 culnaral and regional difierenoes. For example, there may be interpretations of questions by n '_ and some companies may "I then a more conservative I" linestions. Moreover, questionnaires purifies, and feedback rates are usual- ‘ ' "ate assessment universe and ' _' by the companies, lan- global coverage of the assess— acute with regard to Japanese ‘ ‘ the assossor to have all doc— to English. Analysis of on 'isfidlso open to misinterpretation, hm. exemplified by the fact that 1 7 I' sustainability assessth for the potential for errors according to nudism reports.“ In addition, there are in how much infomation actually is I company interviews is very costly, . depends heavily on the availability -W=s.er-u :‘f‘jflf‘tr-cf" are Thus, replicating this is very challenging. ' *the opinion of stakeholders are used . -' new * , j;_ offeedback provided by r” '7: __ _ sagging" efiicient, given the use of Borexample, for the DIS] the Bow Jones interactive database. which covers medium worldwide, is tracked daily. for the assessment is to avoid Whaterpretafimsofdatn. Arman: diallenge ingmhering company information for assessments is the issue of fair dis- closure-to all shareholders. Companies are required by law to provide all shareholders with exactly the same information sons notsogive one shareholder an advantage over another. Many corporate sustainability assessments ask companies forinfortnatiouthatthcyarenotwiflingtopmvidetothe wider financial markets, and this creates gaps in much of the feedback provided to assessors and rating agencies. For each company in the 13331 World assessment, the input sources of infomation for the corporate sustainability assessment consist of the responsos to an online corporate sustainability assessment questionnaire. submitted documen- tation, publicly available information, analysts’ direct con- tact with companies, andlor their main clients and the media. Questionnaires specific to each DJSI World industry group anedistributed via wwwsam-groupcom tocompanies in the 46‘ DIS} World investable stocks universe. The questionnaire is designed to ensure objectivity by limiting qualitative answers through predefined multiple-choice questions. The completed company questionnaire, signed by two senior company representatives to ensure truthfiilness. is the most important source of information for the assessment. For the D151 World, the questionnaire process: has been streamlined to enable companies to answer the questions online. This interactive tool enables a company toupdateaod: - change its most recent updates in the existing and, in turn, facilitates efficient and scum the analyst'lhefeedhack rateofthecorpm’tm . .,‘. . assessment questionnaire has improved from lit-percenti- 1999 to 25 percent in 2001. __ torcducetheenormargin ofdata analysts. — " Analyzed documents include sustainability environ- mental, health and safety, social. and and all other norm of company internal documentation, brochunes, and also review media, press releases. _ commenter-y written about a company past Finally, each analyst pasonally contacts nies to clarify questions arising from analysis of the ques- tionnaire and company documents. Although corporate sustainability assessment information gathering depends heavily on a company’s willingness to participate in the process (which is oftenfietermined by the incentive ofbeing part of the index), the trend toward greater transparency in corporate reporting evenmnlly will allow for more streamlined access to information and. hence, greater efficiency for both assessors and assessees. Quantifying Corporate Sustainability Assessment Results Quantification is clearly a major challenge 'm corporate sus- tainability asSessment, the overall objective of which is to aggregate the performance of a company in terms-of specif- ic criteria into an overall sustainability performanco score. Challenges exist regarding quantification of qualitative data. management of large volumes of company data, and consis— tent objective application of the assessment methodology Qualitative criteria are measured via an ordinal metrics scheme, which allows the differences between companies’ performances to be expressed in such a way that one compa- ny can be identified as better or worse than the next, rather than in absolute score terms. Subsequently, aggregation of the performance scores is done via the weighting of the cri- teria answers, the challenge being to bring the criteria into a meaningful relationship that represents the conect impor- Table 3 Individual Criteria Weightings Weight of Question Weight of Theme Weight of Class Opportunities) (Environmental {Strategic Sustainability Charters] Opportunities) .25 Answer We 1 5 igbt 01 Answer lfluestion 45) Member of more than 100 .40 3 adapted tracers Mariber of 2-3 accepted .56 clam Marthe! of 1 accepted charter .33 No cluttch signed 0 tar-toe of a criterion relative to the overall system. Regarding the potential for subjectivity in this quantification, this is addressed by adopting the Delphi approach of accessing expert input. Moreover, the increased use of information technologies may increase the quality of data management, capacity, and efficiency. For the D151 World, approximately 1,000 companies are assessed yearly and monitored constantly, which requires massive data management skill to ensure effective data capture and analysis to ensure, in turn, effec- tive quantification of corporate sustainability performance scores. Use of an extensive database and introduction of an online questionnaire enhances data security and helps to increase accuracy and data replica- bility and comparability. Corporate sustainability assessment data are open to wide mis'interpretations from both the assessed company and the assessor. It is vital to ensure that subjectivity is minimized while developing a company’s quantified score. Using the same analyst for an entire industry group facilitates a coher- ent application of views. Constant internal assessor training, clear working procedures, and cross-checking by different analysts foster objectivity and accuracy of results. External audit reviews also may be used to ensure objectivity and replicability, both of which are critical factors for an index. The corpomte sustainability assessment enables calculation of a sustainability performance score for each company. Reviewing, assessing, and scoring all available information in line with corporate sustainability criteria determines the overall sustainability score for each company in the D181 World investable universe and, subsequently, allows com— parison of performance and identificatiOn of leading com; panies to be included in the index. In the D381 World, corporate sustainability assessment and subsequent quan- Iification and scoring is conducted in three stages: ques- tionnaire assessment, quality and public availability of Q information, and verification of information. This process is described briefly below: Stage 1: Questionnaire Assessrnem‘ All answers provided in the questionnaire receive a score. Each question has a predetermined weight for the answer, the question, and the theme and class within the question.” The total score for the question is the combination of these weights. For example (see also Table 3): Question 45: Has your company signed environmental charters. or is it committed to the principles of sustainability councilsfcoalitions? D Yes, please specify El No charters signed The weighting of each answer is automatically calculated by the SAM Information Management System and totaled to give a score for the questionnaire. The weight of the questionnaire as an information source depends on whether the questionnaire and answers provided have been approved—in other words, signed by at least one senior management member of the company. If the question— naire is not signed, less weight is given to the questionnaire and, accordingly, more weight is assigned to Stage 2. Stage 2: Quality and Public Availability of Information Company documents and publicly available information about a company are scored according to their scope, cover- age, and ease of access. The scope and coverage of a company’s documentation is evaluated for each dimension: economic, environmental, and social. in this Stage, the analyst assesses how well imple- mentation of policies and management systems is document— ed across the entire company. The evaluation is scored based on the scale portrayed in Table 4. 135 136 Table 4 Level of Scope and Coverage Level of Scope and Coverage Score Criteria Low Cl No documentation or only tew case studies without context or lack of worldwide coverage Medium 1 Acceptable quality of documentation Description of policy/management systemlactivitv. and information about coverage in a systematic way High 2 Good quality of documentation. Strategy, implementation 01 management systems, performance against targets described in detail The ease of access to a company’s publicly available infor- mation and documentation is evaluated for economic, social, and environmental dimensions (see Table 5). This evaluation covers all publicly available documentation as well as infor- mation provided to SAM Research for the assessment. Stage 3: Verification of Information information provided in the corporate sustainability assess— ment questionnaire is verified to ensure that quantification of a company’s sustainability performance reflects reality. The verificatiOn process assesses whether a company implements and commits to its stated policies and management practices. The verification process begins with cross-checking a com- party’s answered questionnaire with documents provided by the company and publicly available documents, which are considered in addition to the issue of public availability of information mentioned above. In addition, the company‘s record is verified by reviewing media and stakeholder reports. If necessary, direct interaction and clarification with the company are also undertaken by the analyst to verify selected parts of the assessment. For each dimension, a sample of company answers is analyzed in depth to verify truthfulness. If the answers provided by the company cannot be validated or are contradicted by informa- tion found in company documents or other publicly available documents, this is reflected in a lower truthfulness factor, which results in a lower allocaan of performance scores. Within this context, the consistency of a company's behavior and management of crisis situations is reviewed in line with its stated principles and policies. Issues Such as commercial prac- tices (for example. tax fraud, money laundering. mtin‘usr issues, balance sheet fraud, and corruption cases}, human rights abuses (for example. cases involving discrimination. forced resertlernenrs, child labor, and discrimination against indigenous people). n'orldorc'c conflicts (for example. also Table 5 — Level of Public Availability level ol Public Availability Score Criteria low 0 No public information Medium 1 Most information is for internal use, some public inlormation exists High 2 Most intormation is publicly available sive layoffs and strikes), and catastrophic events or accidents (for example, fatalities, workplace safety issues, technical fail- ures, ecological disasters, and product recalls) are included in this part of the corporate sustainability assessment. In the internal review, SAM research weighs the severity of the crisis in relation to the company‘s reputation and crisis management quality. If the company fails to meet its stated policies and management practices as found through the review, scores may be reduced or deleted entirely for whole criteria or specific individual questions. In extreme cases, the verification process may exclude companies from the eligi- bility list (decided by the D55] index Design Committee). Based on the three stages outlined above, a company’s total corporate sustainability score is calculated. According to pre- defined scoring and weighting structures, answers provided on the questionnaire by the company are weighted against scores for quality and public availability and for truthfulness of infor— mation. The resulting corporate sustainability score is verified through review of a company’s involvement in critical issues. A company’s total corporate sustainability score at the highest aggregated level is then calculated. Corporate Sustainability Assessment Score Formula: - TS=Z[CLW*CRW*OUW’EAS‘iOAW+DAW*DASl] -OVS for all questions - T8 = Total Score - CLW = Class Weight - CRW = Criteria Weight - OUW 2 Question Weight - OAW = Questionnaire Assessment Weight - DAW = Weight oi Quality/Public Availability, and Truthiulness oi information o DAS = Score for Ouaiiiy/Public Availability, and Truthlulness 0‘. information it AS 2 Answer Score ' (NS = Questio’meire “verification Scare Corporate Sustainability anrl Financial Indexes l '--I U'l Corporate Sustainability and Financial Indexes l in] CI The results of the calculation outlined above are bill-(ti m. ordinal metrics, which means that the scores can only be used for comparison and ranking purposes, not to determine a company's absolute performance score. It is not possible furthermore to use the scoring for weighting purposes. The calculation of the score for corporate sustainability assess- ment is the basis for selection of components for the DIS] World. A key focus in the future will be on how to reconcile this score with shareholder value creation or destruction. Meeting Requirements of Traditional Indexes An index tracking the performance of companies embracing sustainability has to meet the requirements of traditional financial indexes as far as possible,especia]ly with regard to accuracy and reliability of data; transparency and replicabil- ity of the methodology; and processing based on rules, objectivity, and independence. In the following section, we discuss these requirements with respect to the sustainability component and information included in the DIS] World. The traditional index requirements (such as data quality for the index calculation) are not discussed at this Stage because we assume they are subject to the same rigorous scrutiny as all other indexes of the DJGI index family. To ensure accurate and reliable data, the D181 World is reviewed quarterly and annually to ensure that the index com- position accurately represents the top 10 percent of leading sus- tainability companies in each of the D181 World industry groups. Various Information Technology (IT) systems help to increase data quality, verification systems are used as described earlier, and quantified proxies of qualitative information are designed to enable data accuracy and reliability. Moreover, to ensure quality and objectivity, an external audit and internal quality assurance procedures, such as cross- checlting information sources, are used to monitor and main- tain the accuracy of the input data, assessment procedures, and results. in addition to quarterly and annual reviews, the D181 World is continually reviewed for changes to the index composition necessitated by extraordinary corporate actions—for example, mergers. takeovers, spin—oils, initial public offerings, delistings, and bankruptcymaffecting the component companies and their corporate sustainability per— formance. Finally, corporate sustainability monitoring is part of the ongoing review process. Once a company is selected as a member of the DIS] World, its corporate sustainability performance is monitored centinuously. With regard to transparency and mplicabiliry of the method— ology, each of the Dow JonesSustainability Indexes is accompanied by publication of a guidebook" outlining all of the decisions that have been made in development of the e DIE-l t'tpt‘ttnllt it. ltlll.’ a‘e mu 1m; all n! lira -l.,:'io up tttt'rtltont'd in this pupt‘l. It mt lndrs the t‘tll‘pnl'hlt suitmtmlni ity methodology, index leaturt-s and data dleCl'l'llll'dllUll. pct:- odic and ongoing review, the calculation model, and the management and responsibilities of all parties involved. In addition, the primary research of the DIS] World is based on a consistent rule—based methodology, the details of which are transparent via web publication. To ensure objectivity and freedom of bias toward companies and investors fer an independent and accurate corporate sus- tainability assessment and index construction, all processes are reviewed by an external, independent auditor for the D3 SI World. An average error margin for the corporate sustain— ability performance assessment is determined by reviewing a representative random sample of 25 companies among the upper half of the companies that were not selected becauSe of relatively low corporate sustainability performance scores and the lower half of companies selected for the DJ SI World. The average error margin in 1999 was 0.55 percent, 0.72 per- cent in 2000, and in 0.74 percont in 2001. Free availability of dam is assured by publication of all details related to the corporate sustainability questionnaires, criteria groups, weightings used for scoring aggregation pur- poses, overall results, and index components. Finally, to ensure that the index assessment is independent and objecrive, the D151 World has established two important committees. First, the DJ SI World Index Design Committee is solely responsible for all decisions on the composition and accuracy of the DIS] World. In particular, the DIS] World Index Design Committee is solely responsible for all changes to the index methodology, which is detailed in the current DIS] World Index Guide. Second, the D151 World Advisory Committee is composed of independent, third-party profes- sionals from the financial sector and corporate sustainability performance experts. The Advisory Committee advises the DIS] World Index Design Committee on index composition, accuracy, transparency, methodology, and the corporate sus- tainability performance assessment in line with the latest DJSI World Index Guide. Thus, there are many challenges in assessing, measuring, and quantifying corporate sustainability, and the DIS] World approach has been devised expressly to address these challenges. In the next section, we examine the risk and performance attributes of the DIS] World to determine the value and via— bility of developing an index tracking the financial perfor- mance of sustainability leaders as a whole. 137 138 Figure 2 Performance of the DJSl World and the DJ Global 130 $20 110 DJ Global tin US$,TR} 100 iii in; DJSI iin US$.TRi 70 Data until July 31, 2001 DEC. FEB. APR. JUN. AUG. OCT DEC. FEB. APFi. JUN. AUG. OCT. DEC. FEB. APR JUN. AUG. OCT. 'DEC. 1998 1999 1999 1999 1999 1999 1999 17000 2000 2000 2000 2000 2000 2001 2001 2001 2001 2001 2001 Risk and Performance Attribution of the Dow Jones Sustainability World Index The Dew Jones Sustainability World index was launched in 1999 to track the performance of companies that lead in cer- porate sustainability. According to the DJS] World, an invest- ment in the companies leading in corporate sustainability would have yielded a cumulative negative return of —6.9 per cent, or —2.7 percent per year in US. dollars. Volatility hov- ered at around 18 percent for the first 14 months, before dropping to some 16 percent for the last 10 months. As could have been expected, the sustainability leaders thus were not immune to the genera] downturn in equity prices the world has experienced since mid-2000." float adjustments that are comparable to the methods used MSCI World Indexes. Comparing Performance ing all, but not more than. its interim gains. Aggregate performance is generally of less interest than a detailed analysis of its causes. After all, the negative per— formance may be due to factors unrelated to sustainability. Perfon‘nance attribution, as it is called, is usually most revealing when compared to some other universe's indicator. It is tempting to compare the DJSl World to some general global indicator. such as the Dow Jones Global Index (DJ Global), a broad index comprising more than 5,000 compa nies around the world. We will use it for comparison here because the broader an index is. the less overlap there is. This may help in distinguishing sustainability faCtors from other measurement. One riskiacijustcc‘v measure of performance is returns of the D15? World the D3 Global have been —:.”' {gums “dim-GE m6 chbag is Rimmed using {Tb percent and 0.0 percent. rcspcctwer}: We assume the acreage for the DJS], making it a more suitable partner than the Figure 2 indicates how the two indexes have fared in com- parison. From inception of the DJS] World until the end of July 2001, the DJ Global has fared better than the DIS], los— Relative performance needs to be compared on an all-things- being—equal basis, if any specific claim is to be judged. Portfolio theory answers the question of what makes such comparisons by adjusting historic returns for the risks incurred. Since 1999, the DIS} World has displayed an annu- al volatility of 17.12 percent. while the DJ Global has had an annual volatility of 15.27 percent {see Table 6). The DlSI World has thus been more volatile. If this volatility is an unbiased reflection of the risks incurred. then the difference in volatility is big enough to warrant risk—adjusted return the Sharpe ratio. which relates the return a portfolio earned. above what an appropriate risk-free alternative could have earned. to the volatility experienced. Since 3999. the annual Corporate Sustainabilitv and Pisa-Tut ‘ l 'I-l In! Corporate Sustainability and Financial indexes Table ‘6 —______'_'___._._._—_-.-.-—w————-H---v-—"— Return and Risk Comparison since 1999, total worms in U83 0.15! DJ Global Diflerence Volatility 17.1% 15.3% 1.8% fletum -2.7% 0.0% -2.?% Risk-free rate' 4.0% 4.0% — Excess return {5.7% 41.0% 4.7% ' Sharpe ratio 43.39 41.26 —0.13 _______._....._....._._....———-—---—--——-*-——— 'Average of global eurocurrency rates. risk-free rate to have been 4 percent, which yields a Sharpe ratio of —0.39 for the D181 World and of —O.26 for the DJ Global. Yet, calculating Sharpe ratios alone does not provide for a true all-dungs-being-equal basis. Nor is a comparison of Sharpe ratios sufficient to draw conclusions about the sus- tainability case. Three aspects need to be considered when dealing with relative perfOr-mance. They are differences in exposure to common factors, differences in exposure to spe- cific factors, and pure chance. Exposure to Common Factors Over any period, two indexes will be influenced to different degrees by common factors unless their composition is com- pletely equal. Comparison of the composition of DJSI World with that of the DJ Global as of July 31, 2001, reveals that they Were far from equal (see Table 7). First, companies in the Eurozone make up 23 percent of the D131 World, com- pared with some 13 percent in the DJ Global. U.K. compa— nies account for 19 percent of the DIS] World, but less than 10 percent or” the DJ Global. In turn, Japanese companies account for only 6 percent in the DIS] World, while they account for 10 percent in the DJ Global. U.S. companies account for less than 40 percent in the DIS] World, but 60 percent in the DJ Global. There is thus a strong representa- tion of European companies in the D181 World, at the expense of Japanese and US companies?0 The excess weight of some 10 percent in Eurozone compa~ nies implies that the Euro has greater influence on 1318] World’s return that on the DJ Global‘s return. Indeed, some 2 percent of the 1318] World‘s cumulative underperformanCe of 6.9 percent can be attributed to the Ends 25 percent decline during that period. Currency impacts can be controlled for. in part, by calculat- ing indexes on a hedged basis. Other unequal impacts of common factors are much more difi'tcult to control for. One 4- Table 7 Country Allocation of Dow Jones Sustainability Index CountryICurrrencv Allocation (without Emerging Markets) as of July 30, 2001 DJSI 0.) Global Diflerence AustralialNew Zealand 1.03% 1.40% 037% Canada 2.24% 2.19% 0.05% Denmark 0.38% 0.27% 0.11% Eutoland 22.73% 12.83% 9.95% HK/Singapore 0.51% 1.14% 43.63% Japan 15.42% 10.02% 4.60% Numay 0.23% 0.13% 0.10% Sweden ‘ 0.98% 0.83% 0.15% Switzerland 8.13% 2.53% 5.150% U.K. 18.91% 9.81% 9.10% LLS. 38.38% 58.85% 40.41% _________,_,____.____.._———-—-——-— example is the overweight in large-cap companieS. The DJSI World has a much higher percentage of companies with large market capitalization than does the DJ Global. This differ- ence in composition can hardly be controlled for. The signif- icant overweight of large-cap stocks is caused by the assossmcnt process, which starts from a universe of the LWO largest companies worldwide. Some 2,500 small caps that are members of the DJ Global are not assessed. Over periods during which largewcap companies do relatively boner than small caps, the D181 World does relatively better than the DJ Global. The opposite is true as well: there are periods where small caps do relatively better than large caps, as has been the case since January 1999, so the DIS] World will do worse than the DJ Global. At least 1.8 percent of the cumulative underperformance of the DIS] World since its incoption can be attributed to this difference in composition. The DJSI World also has an above average number of "growth" companies—that is, companies that tend to reimburse investors in capital gains rather than in dividends (see Table 8). Whether “growth” is a true characteristic of the sustainability universe is hard to assess. It is tempting to attribute the overweight in “growth” companies to the notion that sustainability companies are embracing global change and seeking opportunities to prof- it from it. so they find investment opportunities where compa- nies nor integrating sustainability considerations do not. This would justify an above average number of “growth” compa- mics. Yet. this explanation is not necessarily the only one possi- ble. In any case, in times when “value” companies outperform “growth” companies, the DJSI will lag the DJ Global. The small overweight in growth stocks has caused another 20 basis points of cumulative underperformance since inception. 139 Ah Table 8 WM Risk Factors in the Index Allocation According to Aegis Global {quin- Bislr Model” factors {without Emerging Markets} percent of standard deviations of developed markets universe, as of July 30, 2001 0.15! DJ Global Difference mm— Success 0.00% 5.20% 6.20% Value 2.60% 4.10% 4.50% Variability in Markets 9.80% 14.00% 4.80% Aegis'Global Equity Risk Model‘“. Barre Inc. Exposure to Specific Factors The “best-in-class” approach applied to the sustainability universe leads to a small number of companies comprising the index. On July 31, 200], the D151 Wurld comprised 225 companies, while the DJ Global comprised 5,029. Thus. each company included in the DIS] World carries consider- ably more weight than in the DJ Global. This make the D] S] World a less diversified universe and, thus, more vulnerable to specific factors. Mispricing of companies and corrections of their miSpriCing is one such factor. The DJSI World is composed as a price index, as equity indexes usually are. Value~based indexes are rare becauso of the difiiculty of assessing intrinsic value. Examples of value-based indexes are trade-weighted curren- cy indexes based on purchasing power parities. Price index- es by definition cannot consider valuation. In addition, the DIS] World selects the leading companies with regard to their market capitalization. If the market capitalization is affected by severe mispricings, and there is no reason why leading companies embracing sustainability should be shielded from mispricings, the D131 will tend to include the more severely mispriced companies within an industry, as long as the sustainability rating is comparable. The impact of a correction of the mispricing of these companies on the D151, therefore, is larger than the impact of the industry- wide correction on the broader index. Mispricings and their subsequent corrections on the st0c1t level have indeed been affecting the D15] World- Lucent Technologies and EMC Corp. are two examples. In the 22 months of its membership in the DIS] World, Lucent alone accounted for a cumulative under-performance of 1.9 percent. EMC Corp. accounted for 2.9 percent of the relative under- performance during its nine months of membership alone. The performance of Lucent Technologies and EMC Corp. was not related to their sustainability rating, but to the recent 1T bubble, so the 13181 World had no means of excluding them. regardless of their rr'tispricing.2 Chance As an unbiased measure of valuation and performance of the sustainability sector, the DIS] World is inevitably prone robe taken as “evidence” for or against the hypothesis of a sus- tainability business case. Interpreted as a portfolio, it will be expected to outperform comparable portfolios, at least in the long run. The reasoning behind this expectation is sound, as mentioned earlier. A portfolio or index of leading companies that embrace sustainability can be expected to appreciate faster than a portfolio or an index of companies that do not address profitable investment opportunities. Investments in such companies promise higher returns and, due to lower business risk, better risk-return ratios. Better performance can thus be errpr on a risk-adjusted basis . Unfortunately, the DIS] World will never be able to prove this reasonable expectation in relation to a comparable index. First, the issue of comparability will remain unsolvable. Difierent exposures to common factors can never be fully controlled for, and the influences exerted can take many years to even out. Second, specific factors come into play when index member- ship is restricted to the leaders within a universe. Third, the impact of pure chance, inherent in any investment, can Override a sound investment case. A soon as chance has to be taken into account, statistical methods have to be used to decide for or against a case. The usual expectation is that the underlying value—added will perSiSt sooner or later and will override all adverse chance influences, and perhaps even different expo— sures to common factors. Little consideration is given to the amount of time and the number of observations needed to make statistical methods applicable and enable them to detect icant differences in performance. In fact, the number of observations needed for supporting any claim of “value-added" is uncomfortably large. For the moment at least, the index cannot help to determine whether investing in companies embracing sustainability is worth- while. It may never do so. Nevertheless, the overall rationale behind this investment thesis is sound. Sustainability may be claimed to produce higher-than-average returns on a risk- adjusted basis. On a before-the-fact basis, portfolios com- prising sustainable companies thus may be labeled “better” investments, with "better" defined in risk—return space, even when the index or the portfolio fails to deliver on the prom— ise after a relatively short period of time. Conclusion To assess the importance and success or failure of sustain— ability indexing and investing. it is crucial to keep the pri— mary goal of sustainability investing in mind—the identification of companies that are best positioned to profit from trends that are redefining the basis for business success. Clearly, the competitive rules affecting industries and bust» nesses are shifting to the company‘s management of risk and Corporate Sustainability and Financial Indexes 79 Corporate Sustainability and Financial Indexes opportunity derived from economic, social, and ecological trends. Leading companies addressing sustainability therefore detiveoompetilive advantage while also reinforcing the likeli- hood of thee: trends becoming reality. Sustainability investing and indexing’s ‘best-in-class” approach aim to identify the leaders. Promoting the fact that competition, in the Schumpeterian sense, is healthy and a driver for continuous innovation shows that this approach addresses one of the basic tenets of our market economy. Therefore, sustainability invest- ing and indexes tracking the performance of leading compa— nies in terms of sustainability are particularly appropriate as an investment hypothesis, compared with negative screening approaches designed to allow investors a direct expression of their personal ethical values. Concerning the methodology for assessing corpomte sustain- ability, there are a number of key challenges. Assessment of corporate sustainability is a very new concept, a lengthy his- tory on which to base judgments is lacking. The assessment methodology descn'bed in this paper is a work in progress, and improvements must be made to align the content toward crite- ria that better reflect companies’ perfonnance and risk attribu- tions. Fmthermore, regional particularities will be given increasing prominence as specialized regional and emerging market assessment approaches are developed. Moreover, there is a distinct dearth of scientific evidence to support the tenets of the sustainability investing hypothesis and approach. Increased collaboration among academia, sci- ence, and business should be promoted to close this gap. This cooperation between the sciences and the private sector will also provide the background for the much—needed standardi- zation of corporate sustainability reporting. Finally, it is premature to draw definitive conclusions regarding the business case for sustainability. As discussed, a much longer time frame is needed to attribute index or fund performance to particular sustainability criteria or strategies. Evidence regarding a positive impact of sustain- ability on outperformance of an index is not conclusive. However, available empirical evidence supports the view that sustainability investing has not led to a long-run-adjust- ed underperformance versus a conventional approach. Measured over shorter periods, risk-adjusted sustainability performance deviates from a conventional approach. Currently, investment biases (such as a regional bias or a slight growth tilt) are potentially the dominating driver of risk-performance differences. Therefore, it is possible to attest that companies mat pursue sustainability do not underperform the wider market in the longer run, although they very clearly deliver major benefits to society and the environment as well as contributing positively to the vibran- cy of the overall economic system. The fact that an index incorporating companies that lead in their approach to sus- tainability shows no negative eflects on risk performance and may in fact, highlight hidden social, ecological, and economic value, explains the dramatic increase in interest in sustainability investing in recent years. References dc Geus. Arie and Peter Senge, The Living Company, Boston: Harvard Business School Press, 1997. Funk Katina, Sustainability and Performance: Uncovering Opportunities for Value Creation London. Cap Gemini Ernst & Young Center for Business Innovation, 2001. Reilly F.K., and KC. Brown, lnvestment Analysis and Portfolio Management, Fort Worth: Dryden Press, 1997. World Commission on Environment and Development, Our Common Future (Brundtland report), Oxford: Oxford University Press, 198?. Endnotes 1 With asaistance from Erica Tucker-Bassin and Colin le Due. www.5ustainability—indexcom www.kld.comlbenchmarltsldsi.html www.ftse4good.com 0"wa Under the terms of Pensions Act amendments that took efiect on July 3, 2000, Britain's pension funds will be required to disclose whether they take lull account of the environmental, social, and ethical impactvol their investments. 6 As promulgated in the Federal Law Gazette, Gesetz zur lie-form der gesetzllchen Altersversicherung und zur Forderung elnes kao ltalgedeckten Altersvorsorgevermdgens Wtersvsrmdgensgesetz AvrnGl. BundesgesetzblartTeil l, 29.06.2001, 1310. 7 Australian Senate Table Orifice, Senate Bills List 2001, p. 40. 8 SSGA. State Street Global Advisers announces CHF 500 million SFll mandate win from Swiss Federal Social Security Fund. press release. May 21, 2001, 9 The United Nations General Assembly established the World Commission on Environment and Development in 1984, also known as the Brundtland Commission latter chair Gro Harlem Brundtland). 10 www.stoxx.com 11 The DJSl World is produced by SAM Indexes GmbH, 5 collabora- tion between Sustainable Asset Management and Dow Jones Indexes. The mam lunction 01 SAM is to provide the teseamh. while Dow Jones lndexes conducts the calculation and distribu- tion functions tor the DJSI. 12 wwwsustainability-indexescomldstworldlguideboolt.htmt 13 www.5ustainability4ndexes.com 14 SAM internal studies to assess the efficiency 01 the corporate sus— tainability assessment methodology. 15 www.5ustainability—indexes.com 16 PricewaterhouseCoopet's audit letter of August 31, 2001, at WWW.SUSlBlnablllIy-lndex.COl'Tl 17 wwwsustainabiltty—inoexes.com lot full disclosure of questions and weightings in the assessment process 1.8 WWWEUSTEiI’iBblIlTyeEHCEXES.COWCllSLWOI'ld/QUIGEDOOK,l'l‘il’Tll 19 This section has been contributed by Mr. Thilo Goodall 20 ll as unhtety. howevel, that US. companies lag others an sustain- ability to the degree Indicated by these figures. Indeed, the con— struction process may account lot part of the U6. underweight. 141 industry for-a fair-comparison within industries, while mm the difficulties of comparing companies across industries. Focusing on industry strata can have an impact on country strata, if sustainability is distributed unevenly across industries within a country. Therefore, no direct inference shouid be trade to the regional distribution of leading companies embrac- ing sustainability. '21 Bciative price movement across strata can thus shift the compo- sition ofthe index if the relative movements are more pronounced in the index than in the entire universe. This has been the case endow-crimes to date with the DJSI World. Large caps have cor- ramedmone than small caps since August 2000, and intermation technology and telecommunication companies have seen their prices-slashed much more than those of companies from other sectors. US companies provide large percentages 01 both large caps and of technology companies. so that about 6 percent at the current- underweight in US. companies can be attributed to rela- tive price movements since inception of the DJSl. Corporate Sustainability and Financial indexes ‘ i G _| ...
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