A Conversation with Rick Redding from the Index Industry Association – Part II

In Part Two of a two-part series, the ETF BILD team sat down recently with Index Industry Association (IIA) CEO to discuss the evolving world of index regulation and its implications for the ETF industry.

Part II – ESG Indexing and Regulation

BILD: Does ESG pose any particularly new, interesting or provocative discussions about regulation?

Rick Redding: That’s a fantastic question, because I think it’s another area where the SEC is thinking about looking at are names of the funds misleading to investors. ESG may be at the heart of some confusion. ESG may mean something to you and it may mean something different to me.    

The issues surrounding ESG are twofold. One is data: every index provider would love to have better data. For illustration, carbon emissions are actually one of the easier ones to define, but significant differences in measurement exist even here.

The problem is not every company, or country, defines carbon emissions the same way, and they don’t even do it the same within the EU. In addition, the French and the Germans don’t agree whether “nuclear is green or not?” Index providers are trying to find better data to create more precise ESG indexes around these differences.

Second is investor preference: if you and I agree on 14 out of the 15 ESG factors, an index provider still has to create  additional indexes. So, ESG is going to be one of the more interesting growth areas in the index space going forward, because there’s a number of complicated issues. European investors have really taken a lead in ESG investing and regulation, and some of the Asian countries are really starting to make a push because of investor demand. You’ve seen the push in the US from the investor side, not necessarily from the regulatory side. 

BILD: So, should some regulators step into, and maybe require the industry to comply with, an agreed upon set of definitions across ESG?

Rick Redding: If you define it now, what happens when better standards and better ways to measure it arise in the couple of years? You don’t want the industry locked into a rigid definition. If your goal is to get ESG into mainstream investments, your goal is to get people to invest more capital into core portfolios based on ESG criteria.

The problem in practice is if you have too many restrictive types of criteria, you may have an index with a very few stocks. A risk manager at a pension plan or an asset manager is going to ask, “How can we invest $500 billion in a handful of stocks?” No matter how well intended the goal is if there will not be sufficient capacity, we have not accomplished anything

Regulators know there’s just not enough capacity in that handful stocks. So, did you make ESG investing a niche market going forward rather than the goal of making ESG the core of investments? Relatedly, one of the areas in ESG that has lagged behind is in fixed income. Investors think about investing in an ESG portfolio in equities, but not implement ESG in  their fixed income portfolios. I believe that will change because we are seeing a lot of good work being done in the fixed income ESG space.

ESG opens up a whole lot of issues and as the market matures, you don’t want the regulators to cut off the innovation—nor do you want to cut off the competition.

BILD: How does the industry itself push ESG forward?

RR: Price comes down in any industry due to mass customization, and mass customization only happens when participants coalesce around definitions and standards. The same is true of ESG indexes.

The US is further behind other parts of the world because the American investor mentality seeks to exclude companies from a portfolio or a benchmark. In other parts of the world, it’s more about can do we be inclusive of high-quality companies that meet their ESG standards.

We should be more inclusionary of high quality companies because it will open up the market. It probably gets you to larger number of stocks in an index, makes it easier for large amounts of money to be invested in them, and allows investors to look at it across multiple factors or criteria and say, “these are companies that reflect our values and our principles.” I think that will go a long way into helping the industry in the US grow.

BILD: Finally, how does outsized demand from investors affect the ESG value chain, from products down to indexes?

Rick Redding: I don’t think most market participants have thought about the value chain and the decision making process.

Underlying ESG indexes and benchmarks will be successful, not because one of the index providers has the magic way to create it, but it really is going to be investor-led and based upon what is it the investors really want. That’s what really pushes the dynamic and that’s especially true in the US whereas in Europe, regulations are leading. As discussed earlier, the risk in Europe is that regulatory intervention could hamper innovation.  

In the US, It’s the investors who need to say +, “this is what we want; this is what we agree on; this is what we want you to build.”

That is promising, not only to foment faster uptake, but gain broader acceptance. So, I’m encouraged that it’s the investors at the end of the day that will the revolution in the United States—rather than regulators.