Innovation In ESG Index Investing

ESG index funds empower investors to vote with their feet by investing specifically in companies with high sustainability profiles, without compromising on investment returns.

IN A NUTSHELL

• Historically, the index-tracking investment industry has offered limited choice in sustainability-focused indexation funds.
• 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 returns.

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.

Sustainability Indices

Morgan Stanley Capital International (MSCI), a leading index provider, has collected sustainability-related data through its in-house 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 firm-specific 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.

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.

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 plain-vanilla market capitalisation fee to track an MSCI ESG index.

Market reception

Over 1 200 asset owners, investment managers and professional service partners have become signatories of the UN-backed Principles for Responsible Investment (PRI). Broad acceptance of these practices has translated into strong demand for sustainability-themed investment products.

MSCI has reported that about US$25 billion is currently tracking their suite of sustainability indices. There has been a recent surge in inflows of about US$8 billion over the last 24 months (from May 2015).

Work done by Campden Research shows that the global market in ESG investments is expected to grow at a rate of approximately 25% a year. We expect the growth of ESG indices to be buoyed by growth in the broader ESG investment market.

Investors’ say

Innovations in investment indexation have allowed index-tracking managers to incorporate ESG factors into their investment process. Index-tracking products can offer investors the opportunity to send signals to capital markets that sustainability considerations are of prime importance, without adversely affecting the risk-return characteristics of an investor’s financial returns.

In essence, it empowers investors to vote with their feet, by investing only in companies with high sustainability profiles, without compromising on investment returns.

References

MSCI Global Sustainability Indices Methodology (June 2013)

MSCI Factsheets

Trends in ESG Integration in Investments (BSR)

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