3 key changes for your radar as the world shifts toward the new economy

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The world has already rapidly shifted towards the new economy. As it stands today, one sector out of 11 currently accounts for a fifth of the MSCI World Index - technology. While energy - the clear winner of the industrial revolution - currently makes up roughly 5%. 

20 years ago, it was a very different picture. Energy made up 20% of the index, while technology was only about 8%. However, according to State Street Global Advisors' Yvette Murphy, there's still change on the horizon - as capital shifts away from traditional energy sources and repositions itself towards greener technologies and materials. 

"That's not selling out of energy and buying tech or financials. That is redeploying capital within all sectors across the global equity universe to carbon leaders, to transition leaders, and to leaders in green technology to support that responsible transition going forward," Murphy said.

In this Expert Insights video, Murphy shares three key areas that are set to evolve over the coming years within this burgeoning thematic, including portfolio allocation, new metrics and an ever-quickening pace of change. 

Note: This interview took place on Tuesday 2nd August 2022. You can watch the video or read an edited transcript below.

Edited Transcript

Has ESG index investing been held back by the fact traditional indices are weighted towards the ‘old economy’? 

Yvette Murphy: I don't think ESG indexing is being held back by the old economy's representation in the market cap indices. I think there's certainly been a huge amount of proliferation in ESG indices in the last five years. Some are definitely more anchored towards the market cap index whereas some are very niche - with sector or industry-specific targeting, and specific themes of renewable energy, or critical minerals for batteries. So from a practitioner standpoint, I think we're in safe hands with the future of ESG indices and innovation.

I think what is important to understand though is how the real world economy and the market cap index interact and where the old and the new economy sit within that realm. By old economy I mean, companies that were successful or contributed to the success of the industrial revolution. Think big energy, big mining, big industrials and the new economy being those companies that have contributed to the success of the technological revolution. So the big IT players and consumer discretionary.

So when we think about the traditional market cap index, let's use the MSCI world as a proxy. I would actually say that it is reflecting the new economy now. The weight of the IT sector is over 20%. One sector out of 11 is accounting for a fifth of the market cap of global equities. 
Energy is currently sitting at 5%. If you reverse that, if you look at what that was like 20 years ago, technology was about 8% and energy was over 20%. So we have seen that transition occur in global equity markets.

But as it relates to climate investing, that's actually not the real problem. The market index weighting scheme is not the problem that we're ultimately trying to solve. It's the fact that the real economy is still really heavily reliant on traditional conventional energy sources. So what we're trying to do with ESG indexing or ESG/climate strategies is to shift capital toward the new economy. And that's not selling out of energy and buying tech or financials. That is redeploying capital within all sectors across the global equity universe to carbon leaders, to transition leaders, and to leaders in green technology to support that responsible transition going forward.

What will ESG investing look like in five years’ time? 

The pace of change has been incredible - much more than any other thematic that I've seen in my, albeit short, career. I think certainly ESG and climate investing will depend a lot on what the real economy looks like in five to 10 years. 

I would be too optimistic to expect the world to decarbonize in 10 years and then a climate strategy is simply the market cap strategy. But in lieu of that, I think there are three key areas within ESG and climate investing that will evolve.

1. ESG and Climate Investing's role in portfolio allocation

The first is around its role in portfolio allocation. So previously, ESG investing was typically reserved for the niche parts of a client's portfolio. The biggest philosophical shift we've seen in our investor base to now is to take that decision-making and put it into a much bigger part of the portfolio, the core equity component of a portfolio. So this naturally augments the traditional emphasis on risk and return to ESG and climate considerations alongside those.

2. Development of forward-looking metrics

The second key area of development is around the metrics that we use. The industry's constantly awash with new data, and new data providers, each providing the best, most unique, most robust data point. So I expect that there will continue to be innovation and increased robustness and granularity in that field. 

As it relates to climate, I think forward-looking metrics are definitely going to become commonplace in climate investing. Up until now, climate strategies have typically relied on backward-looking measures of climate assessment. So think carbon intensity per revenue from their last financial year, the source of brown revenues or the source of green revenues - all of that is from company financial statements in the past. Climate change is certainly about the future though and so understanding metrics that capture the pathway or the trajectory going forward is going to be really important.

3. Rapid pace of change

Then the third area is simply around the pace of change. So you asked me what climate investing looks like in five to 10 years. I actually think, what does it look like in two years? The amount of technology, the amount of regulation, and the amount of standard setting that is going on means that we are constantly having to assess our strategies to make sure that they are actually doing what they say on the label. That we're aligned with the latest science and we're aligned with the latest guidance and pathway analysis.

Seeking climate exposure and capital growth?

State Street gives investors access to the most efficient trade-off between climate targets, ESG improvement, tracking error and diversification while seeking long-term returns broadly in line with the Index.

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