Understanding Key Performance Indicators

Posted by FlexShares on Aug 28, 2017 8:30:00 AM

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Key performance indictors (KPIs) are quantitative and qualitative metrics reported by public companies as part of their regulatory filings. Many KPIs relate to ESG factors. As ESG investing continues to become more mainstream, investment managers have begun to use ESG-based KPIs as part of their screening process in building ESG indexes and funds. ESG-based KPIs span environmental, social, and governance factors. Here are some examples.

Environmental

Numerous environmental KPIs exist and are evaluated by financial advisors. Some are universal and apply to many companies across a variety of sectors. Others may be specific to a narrow scope of companies. These might include:

  • Electricity usage
  • Water usage
  • Environmental risk exposure
  • Nitrous oxide emissions [1]

Analysts might also look at programs in place to manage environmental issues, examining, for example, whether the company is certified against standards such as ISO 14001. [2]

Social

Examples of social KPIs include:

  • Fatalities per 1,000 employees
  • Community spending
  • A company's human rights policies
  • The amount spent in the company's community

Social KPIs can tell investors a lot about a company's relationships with various stakeholders, including suppliers, employees, and their community.

Governance

Examples of governance-related KPIs include:

  • Executive compensation
  • Board diversity
  • Anti-corruption policies
  • Board independence

Governance KPIs can tell investors whether the company uses accurate and transparent accounting practices, as well as whether the company allows shareholders to vote on important issues facing the company. The governance variable is also interested in learning about the company's ethics in matters such as avoiding corruption and eschewing political contributions to gain favorable treatment.

Morningstar Sustainability Rating

Morningstar came out with its sustainability rating for mutual funds and ETFs in 2016. They analyze the companies in a fund's portfolio and assign the fund a sustainability rating based on a set of ESG KPIs. They then deduct from that score based on any controversies in which the fund's holdings are involved. These rankings allow investors to evaluate funds and ETFs based on a standardized sustainability rating system. [3]

How we use KPIs

FlexShares launched our two ESG-based funds in July 2016:

  • FlexShares STOXX® ESG Impact Index Fund (ESG)
  • FlexShares STOXX® Global ESG Impact Index Fund (ESGG)

The funds are based on the STOXX® ESG Impact Index and the STOXX® Global Impact Index, respectively. The indexes screen companies that score higher on a selected set of ESG KPIs. The companies scoring in the bottom half of the investable universe are eliminated from inclusion in the index, as are companies that do not adhere to the UN's Global Compact principles, including those who are involved with controversial weapons or who mine coal as part of their business. [4]

Our research shows that this rigorous methodology parallels the methodology that investment managers already employ when screening companies for more traditional investment factors. In our opinion, the best way to integrate ESG KPIs into the investment process is to identify the materiality of each KPI in terms of its impact on investment results. Material KPIs should impact a company's risk and return with a high level of predictability. Companies that score poorly on these key KPIs pose a risk to investors, as violations in these areas can pose tangible financial and business threats to a company's bottom line and, ultimately, their stock price. [4]

Written in conjunction with Roger Wohlner utilizing Contently. Roger is an experienced financial writer whose work has appeared on Investopedia, US News, Morningstar Magazine and MSN Money.

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References

[1] ETF Database, “What You Get With ESG Themed ETFs," Max Chen, September 1, 2016, https://www.etftrends.com/2016/09/what-you-get-with-esg-themed-etf-strategies/

[2] Columbia Threadneedle.com, " ENVIRONMENTAL, SOCIAL AND GOVERNANCE INDICATORS AND KEY ISSUES REFERENCE DOCUMENT," http://www.columbiathreadneedle.com/media/4956293/en_esg_indicators_and_key_issues.pdf

[3] Morningstar.com, "Introducing the Morningstar Sustainability Rating for Funds," by Jason Hale, March 17, 2016, http://beta.morningstar.com/articles/745796/introducing-the-morningstar-sustainability-rating-for-funds.html

[4] ETF Database, “Taking a Bottom Up Approach to ESG ETF Investments," Max Chen, July 27, 2017, https://www.etftrends.com/smart-beta-channel/taking-a-bottom-up-approach-to-esg-etf-investments/

FlexShares STOXX® US ESG Impact Index Fund (ESG) and the FlexShares STOXX® Global ESG Impact Index Fund (ESGG) are passively managed and use a representative sampling strategy to track their underlying index respectively. Use of a representative sampling strategy creates tracking risk where the Fund's performance could vary substantially from the performance of the underlying index. The Funds are subject to environmental, social and governance (ESG) Investment Risk, which is the risk that because the methodology of the Underlying Indices selects and assigns weights to securities of issuers for non-financial reasons, the Funds may underperform the broader equity market or other funds that do not utilize ESG criteria when selecting investments. The Funds are also at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. For ESGG, investments in foreign market securities involve certain risks such as currency volatility, political and social instability and reduced market liquidity. The Funds may also invest in derivative instruments. Changes in the value of the derivative may not correlate with the underlying asset, rate or index and the Funds could lose more than the principal amount invested.

The STOXX® USA ESG Impact Index and the STOXX® Global ESG Impact Index are the intellectual property (including registered trademarks) of STOXX® Limited, Zurich, Switzerland and/or its licensors ("Licensors"), which is used under license. The securities based on the Index are in no way sponsored, endorsed, sold or promoted by STOXX® and its Licensors and neither of the Licensors shall have any liability with respect thereto.

Tags: ETF

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