Integrating ESG into Factor Index Solutions

    by Marcin Wojtowicz, PhD ETF & Index Fund Investment Analytics UBS Asset Management

    Investors are increasingly looking to integrate ESG considerations into factor investing. This requires a balancing act between tilting the portfolio towards factor characteristics and meeting ESG objectives. Let us look at how investors can combine these two objectives with index-based factor strategies.

    “Constructing a standard factor index is about defining the relevant factor metrics, which are then used for stock selection and tilting weights to increase factor exposure.”

    Florian Cisana, Head of UBS ETF & Index Fund Sales Nordics

    Constructing factor indices

    Before delving into ESG integration, we first provide a short overview on the construction of traditional factor indices. In this article, we will focus on quality and value factors. The starting point here is to decide on the most appropriate metrics to capture a given factor exposure.

    • Value criteria: Price-to-Book Value, Price-to-Earnings, Price-to-Sales, Price-to-Cash Earnings
    • Quality criteria: Return-on-Equity, Debt-to-Equity, Earnings-Variability

    By using these company-level metrics, we can assess the factor exposure of each company in the investment universe (e.g. MSCI USA index). To ensure comparability, it is typical to standardize these metrics by creating z-scores. These can be further aggregated into composite z-scores corresponding to the specific factor (value, quality), which can be interpreted as factor loadings. The higher the value of the z-score, the higher the factor exposure.

    In an index-based approach, a factor portfolio can be constructed by selecting only those companies from the parent universe which have relatively high factor loadings (e.g. including 25-30% by market capitalization). Furthermore, the weighting of portfolio constituents may be linked to market capitalization as well as factor exposures (z-scores) to further tilt towards the targeted factor.

    ESG integration

    In our view, a comprehensive ESG overlay should include several components such as business activity exclusions, promotion of higher ESG rated companies, and a carbon footprint reduction. In particular, sustainability ambitions can be defined as follows (based on MSCI data).

    1. Exclusions: UNGC violations, tobacco, weapons (controversial, nuclear, military, civilian), thermal coal mining, unconventional oil and gas extraction, thermal coal power generation
    2. Minimum ESG standards: minimum MSCI rating of BB and minimum controversy score of 1
    3. ESG score improvement target of +20%
    4. Carbon footprint reduction by 30%, potential emissions (fossil fuel reserves) reduction by 30%

    Applying business activity exclusions [1] and minimum ESG standards [2] is straightforward and typically  reduces the eligible universe by single digit percentages as measured by market capitalization.

    Interplay between factor exposure and ESG considerations

    The key challenge lies in balancing at the portfolio level between:

    1. factor exposure
    2. an improvement in ESG score [3]
    3. a reduction in carbon footprint [4].

    In essence, it is a multidimensional optimization problem.

    We examine the relationship between the value factor exposure and ESG score for the MSCI USA universe (Figure 1), using MSCI ESG data. The most desirable companies are characterized by above average ESG scores and high value factor loadings (z-scores).

    Figure 1. MSCI USA universe: ESG scores vs. value factor z-scores

    The bubble area represents the weights of companies in MSCI USA index. The horizontal blue line represents the average (industry-adjusted) ESG score of 6.3, while the vertical blue line represents the average value z-score by construction equal to 0.0.

    Source: MSCI, UBS Asset Management. Data as of December 2022 index rebalancing. For illustrative purposes only.

    What are the two methods to create a factor ESG portfolio?

    Option 1. A two-step approach: ESG integration followed by factor selection.

    For example, ESG integration could aim to include the top 50% of highest ESG rated companies. The second step would be a selection of the top 50% of companies with the highest value loadings (z-score).

    This selection is represented by the top right quadrant of Figure 1. In this quadrant, there are 124 companies (note that the MSCI USA has 625 constituents) with an aggregate weight of 13.7%.

    The caveat is that ESG score improvement reaches 13.9% compared to MSCI USA, while carbon intensity is actually 160% higher. A two-step approach would thus require further refinements to meet the previously outlined ESG ambitions.

    The weakness of this approach lies in its inability to jointly assess companies based on the three criteria (factor exposure, ESG score [3], carbon footprint [4]). To illustrate the point: a company with a very high factor loading may be just below the ESG threshold, while a company having an insignificantly better ESG score may pass despite having a significantly weaker factor loading. It leads to unnecessary erosion of factor exposure that is required to meet a targeted ESG improvement.[1]

    Option 2. Optimized approach: optimization procedure with the objective to maximize the portfolio exposure to the value factor (z-score), subject to the constraint of meeting the ESG improvement target (+20%) and carbon intensity reduction (-30%).

    The optimizer not only selects a subset of companies, but also reweights portfolio constituents, while a number of conditions are imposed to ensure sufficient diversification.

    • Tracking error limit: 10%
    • Sector active weights: +/- 20%, country active weights: +/-20% but more stringent for smaller countries
    • Number of constituents: minimum 100 or at least 25% of the number of constituents in the parent index rounded to the nearest 10
    • Maximum overweight of a constituent by a factor of 10 vs. the parent index weight, but the overweight is not greater than by +2% in absolute terms
    • Minimum constituent weight: 0.05%
    • One-way semi-annual turnover: 20%

    This approach provides a flexible framework that can be applied to different factors (e.g. quality, value, volatility) and across different universes (MSCU USA, MSCI EMU).

    A framework like this is used in the MSCI USA ESG Quality Low Carbon Select [LCS] index and the MSCI USA ESG Prime Value LCS index.

    The latter is a value index that additionally applies a quality pre-screen which removes one-third of companies with the lowest scores based on quality metrics. Its purpose is to avoid value traps, which are companies that exhibit strong value characteristics (e.g. low P/E) but for the very reason of questionable financial viability. Let us look at this portfolio in more detail.

    MSCI USA Prime Value ESG Low Carbon Select index

    The MSCI USA Prime Value ESG LCS index portfolio is indicted in Figure 1 with dark grey colour; it includes 104 companies with an aggregate market cap weight of 17.0% vs its parent – the MSCI USA index. We can see the optimizer makes trade-offs between factor exposures and ESG scores: at times a company with a lower factor loading enters the portfolio because it has a high ESG score and vice-versa. Clearly, companies with below average ESG scores and below average value factor loadings are excluded (bottom left quadrant in Figure 1).

    The portfolio fulfils all objectives; MSCI USA Prime Value index has a value exposure that is significantly higher compared to MSCI USA (z-score of 0.34[2] vs -0.13 [3], while it meets the ESG target improvement (+20%) and exceeds the carbon reduction target (-49%).

    Table 1. Comparison of selected metrics (averages weighted by market capitalization)


    The performance of the mentioned factor ESG indices has been similar to standard factor indices (Figure 2). Since 2013, the Value ESG index underperformed its standard Value equivalent by 25 bps per annum, while the Quality ESG index outperformed its standard factor equivalent by 81 bps per annum [4]. Also, correlations in daily excess returns between the two Value and Quality indices has been at 0.86 and 0.79, respectively, which further demonstrates similarity.

    Figure 2. Historical performance of selected factor indices relative to MSCI USA

    Source: MSCI, UBS Asset Management. Data as of 28 April 2023. – Index level data for factor indices contains live and back-tested data. Past performance, whether simulated or actual, is not a reliable indicator of future results. For illustrative purposes only.


    Integrating ESG into factor indices can be achieved with an optimized approach that efficiently balances between achieving factor exposures and sustainability objectives. Historical simulations demonstrate that factor ESG solutions can be considered as a good alternative to their traditional counterparts.



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    [1] For a more detailed discussion on this topic, we refer to MSCI publication ‘The MSCI Factor ESG Target Indexes’ (September 2017)

    [2] This portfolio average value z-score is weighted by market capitalization.

    [3] The value is -0.13 because it is the market cap-weighted average. For arithmetic mean, the value is 0.0.

    [4] The factor ESG indices are primarily based on backtested data.



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