Keep in Broad: An Approach to ESG Strategic Tilting

(MSCI) – Institutional investors are increasingly looking for ways to integrate ESG considerations into their investment decisions. By doing so, they may aim to mitigate long-term risks, generate higher risk-adjusted performance and/or align investments with broader societal objectives. As ESG investment guidelines become more commonplace among asset owners, and as many continue to build capabilities in engagement and risk management, we have seen a small but growing set of institutional investors focus on long-termism by adopting investment strategies that explicitly build in their holistic views of the future.

Historically, investors have relied on either exclusionary or selection-based ESG index strategies, whereby companies would be screened out from an investment universe due to their involvement in controversial activities or selected due to strong ESG performance against sector peers. However, both approaches reduce the investable universe and have proven to be challenging for the largest asset owners, often referred to as universal owners, whose portfolios span the entire equity market. Additionally, approaches that exclude companies altogether may preclude opportunities to engage or incentivize progress.

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In this paper, we examine a potential strategy to ESG tilting designed to target companies demonstrating both a robust ESG profile and a positive ESG trend while maintaining minimal exclusions. Such a strategy can be illustrated by the MSCI ESG Universal Index. We start by defining an investable universe minus a core set of exclusions that include involvement in controversial weapons and violations of international norms. We then utilize both static and dynamic ESG performance indicators to weight the remaining stocks in a way that preserves diversification and balances the concerns of universal owners.

Our findings highlight that the MSCI ESG Universal Index, which is designed to represent the returns of this strategy, demonstrated an annualized outperformance of 20 bps and a risk reduction of 30 bps compared to the parent MSCI ACWI Index for the period ranging from November 2009 to July 2016 while exhibiting a low tracking error with minimum sector and country bets using back-tested data1. The index demonstrated a significantly higher ESG profile overall and across each of the three environmental, social and governance pillars. Finally, the carbon footprint of the index was reduced by 14%.

As more investors integrate ESG into their investment process globally, such an index could potentially be used by asset owners as they determine their strategic asset allocations or implement their ESG investment strategies.

View the MSCI report here: KEEP IT BROAD: AN APPROACH TO ESG STRATEGIC TILTING

KEEP-IT-BROAD_-AN-APPROACH-TO-ESG-STRATEGIC-TILTING
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