Does the Underlying Design of Environmental, Social, and Governance (ESG) Indices Affect Investor Reactions? The Role of Legitimacy and Reputation Effects

The growing importance of socially responsible investments is causing a rapid increase in the number of various ESG indices. This raises the question of whether the index design matters to stock market investors. The purpose of the article is therefore to analyze the impact of ESG index design on investor decisions motivated by announcements of index reconstitutions. It was assumed that information about company additions to, or deletions from, an index—signaling an improvement in or deterioration of its CSR standards—may be differently interpreted by investors depending on the context provided by the index design. This study used data on the reconstitutions of two ESG indices. One of them, FTSE4Good US, is based on negative screening. Due to its design, membership in it is strongly associated with legitimacy. The other index, DJSI North America, is a best-in-class index which confers a reputation effect. We have applied the event window methodology, which identifies the economic effects of an event by estimating its impact on share prices as reflected in the rate of return. Analysis encompassed 691 events concerning American listed companies in the years 2009–2019, of which 441 were additions and 250 were deletions. It was found that significant investor reactions were triggered only by reconstitutions of the index generating a reputation effect (DJSI). These results indicate that index design does matter. The reactions of investors were positive only when they associated a company’s social commitment with the creation of intangible resources contributing to its competitive advantage. Our results suggest that inclusion in a best-in-class index is more beneficial for a company than in an index based on negative screening.