The trade-offs that come with ESG index construction

Like any investing decision, saying ‘yes’ to ESG requires giving up some ground on other portfolio dimensions

The trade-offs that come with ESG index construction

Students of ESG investing are likely aware of different approaches, ranging from negative screening to integration and best-in-class security selection, that reflect varying attitudes and styles. But aside from catering to different investor preferences, variations in the approach can have implications on the features of the end portfolio.

MSCI made this point abundantly clear in a recent paper titled Understanding MSCI ESG Indexes, in which various MSCI ESG indexes that are derived from the MSCI ACWI were compared. One analysis looked at how the level of ESG quality achieved by an index possibly correlates with the diversification and market-cap coverage of its underlying portfolio.

“Not surprisingly, the indexes with the lowest level of ESG quality (MSCI ESG Universal and MSCI ESG Screened) had the broadest and most diverse portfolios with market-cap coverage not far below 100%,” the paper said. In contrast, the MSCI SRI index, which selects the 25% best-in-class companies, exhibited the highest level of ESG quality as well as the highest portfolio concentration.

The middle range of the trade-off, it noted, is found with the MSCI ESG Focus Index. It uses index-weight optimization to achieve considerably higher ESG quality, while maintaining a more diverse portfolio, compared to the MSCI ESG Leaders Index, which layers a 50% best-in-class selection per sector and sub-region process with a market-cap-weighted approach.

“[W]e can observe the relative advantage of using an optimization process in the index construction versus a simple best-in-class selection,” MSCI said, though it conceded that the MSCI ESG Leaders index follows a simpler and more transparent index-selection methodology.

Looking at ESG quality versus tracking error, the firm also found a trade-off. The MSCI ESG Focus Index once again proved to be an ideal middle ground; it achieved higher ESG-quality per unit of tracking error compared to the MSCI ESG Leaders Index using an explicit tracking-error constraint in its index optimization process.

The MSCI ESG indexes were also found to have higher turnover levels than their parent benchmark. Aside from inheriting the turnover of the MSCI ACWI, they also get additional turnover from the change of ESG characteristics. Notably, the MSCI ESG Universal Index employs atilt that uses both MSCI ESG ratings and MSCI ESG momentum scores — a measure of how quickly companies’ ESG scores improve or go down.

“MSCI ESG Universal showed higher turnover than MSCI ESG Leaders and MSCI SRI, because its ESG tilt uses both MSCI ESG ratings and MSCI ESG momentum scores, which both drive turnover,” the report said.


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