Sudan, Syria, Iran and North Korea have been identified by the U.S. government as sponsors of terror—you could probably think of them as a revised and expanded Axis of Evil—and pension funds are increasingly backing away from companies that have business ties to those four countries.

FTSE has responded to the trend by entering into an agreement with independent research provider Conflict Securities Advisory Group (CSAG). The two firms have partnered to create indexes that screen out companies that do business in or with the four targeted countries. 

Whether by choice or because of divestment legislation, more and more public pension funds have been divesting themselves of investments in companies with ties to those four countries. For example, California's two public state pension funds, CalPERS and CalSTERS, can no longer invest in companies that have business ties to Iran. Florida law bans its state pension funds from investing in companies doing business with or in Sudan or Iran's energy sector. And the employee retirement systems of both Missouri and New York City have opted for "terror-free" investment policies. It's not only public pension funds that are making these changes: private-sector pension funds are also adopting similar policies, but not because they are legally required to do so. 

The FTSE/CSAG Terror-Free Index Series will be launched in 2008. Currently, screened versions of the FTSE All World ex-US Index, the FTSE All World Developed ex US Index and the FTSE Emerging Markets Index are planned. It is not yet known how many companies will be excluded because of the screening process, but the CSAG Web site puts the number of companies in the U.S. and abroad with business ties to terror-sponsoring countries at approximately 400.

So far, there are no plans to include the U.S. in the new series, which makes sense, as U.S. law blocks domestic companies from conducting business in or with these countries, for the most part. However, companies domiciled outside the U.S. often do not face those sorts of restrictions from the governments of their home countries.

With pension plans frequently using index-based investment schemes for their domestic and international allocations, demand for terror-free indexes is likely to increase for two reasons. First, determining the companies with business ties to terror-sponsoring countries has the potential to be expensive and labor-intensive, so an index that already excludes those companies could save time and money. Second, when pension funds use standard indexes and simply exclude the forbidden stocks, they risk added tracking error.

It will be interesting to see what happens when the FTSE/CSAG indexes are launched. Although they screen out companies to ties with Iran, North Korea, Sudan and Syria, not every pension plan with country-specific divestiture requirements necessarily excludes all four of those countries. This raises the possibility that the new indexes could actually encourage pension funds that exclude some of the countries to take the extra step and exclude all of them.

CSAG is a Washington D.C.-based firm and specializes in providing research on companies with business ties to Iran, North Korea, Sudan and Syria.