Innovation in ESG index investing
IN A NUTSHELL
- Historically, the index-tracking investment industry has offered limited choice in sustainability-focused indexation
- Innovation has broadened the scope for investors to get meaningful exposure to environmental, social and
governance (ESG) factors.
- The MSCI World ESG Index assigns an ESG rating to all the constituents of its parent index based on its Intangible
Value Assessment (IVA) of each constituent company.
- The MSCI World ESG Index is sector and region neutral relative to the parent index, which limits the exposure to
the risks associated with having sector or regional biases.
- Some US$25 billion is currently tracking MSCI’s suite of sustainability indices, with about US$8 billion invested
over the last 18 to 24 months.
- ESG index funds empower investors to vote with their feet by investing only in companies with high sustainability
profiles, without compromising on investment returns.
Historically, index-tracking investment managers have
had limited scope to incorporate environmental, social
and governance (ESG) factors into the investment process.
This is because the investment universe is determined
by the indices we track, which have generally been pure
market capitalisation weighted indices that capture broad market
Innovation in the investment indexation space in recent years has
broadened the capabilities that index-tracking investment managers
are able to bring to the market. This article provides more detail
on indexation innovation in the sustainability space, which has
enabled index-tracking investment managers to provide meaningful
exposure to ESG factors.
Morgan Stanley Capital International (MSCI), a leading index
provider, has collected sustainability-related data through its inhouse
research capability, enabling it to launch a suite of sustainability
indices. We have chosen their MSCI World ESG Index, to
demonstrate the methodology used in constructing these indices
and highlight the value they can offer to investors.
The MSCI World ESG Index assigns an ESG rating to all the
constituents of its parent index, the MSCI World Index, which is a
pure market capitalisation weighted index. The rating is based on
its Intangible Value Assessment (IVA) of each constituent. The IVA
is an industry-specific and a forward-looking assessment of a
company’s material ESG risks and opportunities.
An Impact Monitor Report is also generated for each constituent,
which is a backward-looking assessment of the company’s ESG
controversies/controversial decisions, especially those that make
headlines. The companies are then ranked based on their IVA
ratings, and the top 50% of companies (based on market cap) in
each industry are selected for inclusion in the MSCI World ESG
Index. Companies that have an Impact Monitor controversy
assessment below the given threshold are not eligible for inclusion
in the Index, regardless of their IVA rating. The stocks selected for
inclusion are then weighted by their market capitalisation.
What, no apple inc.?
The MSCI World ESG Index primarily provides investors with
exposure to companies that have a high sustainability profile.
This is particularly attractive to long-term investors who value
sustainable economic themes, given their extended investment time
horizon. By removing 50% of the companies in each sector, the
Index is able to remain sector and region neutral relative to the
parent index, which limits exposure to the risks associated with
having sector or regional biases. By picking the best-in-sector
companies, the MSCI World ESG Index is not exposed to the firmspecific
risk of companies with the least sustainable characteristics.
We can demonstrate the company-specific risk inherent in the Index
construction methodology by looking at the information technology
(IT) sector. In the MSCI World Index, Apple (1.9%) has the largest
market capitalisation in the Index’s total universe, and therefore
in the IT sector as well.
However, it has been omitted from the MSCI World ESG Index as
there are significant concerns with regard to:
- the alleged price fixing of e-books;
- certified class action representing 20 000 hourly wage employees
alleging violations of California labour laws over rest periods
and paycheck timeliness;
- Foxconn employee suicides; and
- environmental performance criticisms by the Institute of Public
and Environmental Affairs, an NGO in China.
The graph below highlights how the exclusion of Apple from the
MSCI World ESG Index has not detracted from the Index
Given that half of the IT sector, including Apple, has been excluded
from the MSCI World ESG Index, the IT stocks that are chosen will
have a double weighting when compared to the parent index. The
best-in-sector IT counters currently in the MSCI World ESG Index
include Google, IBM and Intel.
The weighting of the constituents based on their market capitalisation,
along with sector and regional neutrality, means that the MSCI
World ESG Index has a low realised tracking error (similar risk
profile) relative to its parent index. As such, the Index does not aim
to generate alpha, i.e. returns exceeding those of the parent index.
This graph shows the cumulative gross returns (US dollar) of the
MSCI World ESG Index and the MSCI World Index.
Organic, at the same price
So why bother to incorporate ESG factors into their investment
process if it will generate broadly similar returns? The key difference
is the increased sustainability quality of the ESG index constituents
when compared to the parent index.
The table illustrates that the MSCI World ESG Index has a significantly
greater exposure to companies with higher ESG ratings relative to
its parent index, on a market cap weighted basis.
On the outside, a machine-fed chicken may resemble a farm-raised
one – but the organic product’s underlying nutrients (read constituents)
are more nutritious, given they have less toxins. In this analogy,
our support of organic agriculture – by voting with our money –
encourages more farmers to improve their sustainability practices.
The same principle applies when deciding to invest in an ESG
index. By choosing such an index, you don’t compromise the market
capitalisation exposure, but you vote in favour of sustainability with
your investment money.
So, essentially, you are getting the organic alternative at the same
price, as long as the manager does not increase its current plainvanilla
market capitalisation fee to track an MSCI ESG index.
MSCI Global Sustainability Indices Methodology (June 2013)
Trends in ESG Integration in Investments (BSR)