In the second of two articles about the development of ESG indices at MSCI, SRP spoke to Ulrich Stoof, EMEA product manager, derivatives licensing, and Christine Chardonnens, executive director and product manager for ESG indices at MSCI about the creation of Environmental, Social and Governance indices, the relevance of each of the factors for the creation of separate indices, and what drives the index provider in this world.
"A substantial part of the MSCI business is linked to the institutional buyside, so non-customised MSCI and even most customised indices are designed as benchmarks; they are relatively neutral and a lot do not include specific filters to tilt the index towards characteristics beneficial for a specific investment product type," said Ulrich Stoof, EMEA product manager, derivatives licensing at MSCI.
"They are more designed as a market representative, with the purpose to covering trends or a market specifically," said Stoof. "For example, if you look at MSCI market cap indexes, such as the MSCI World Index or Emerging Markets Index, they are not capped by number of stocks, because the equity market is evolving. We create these indices with the goal of having a representative universe of stocks. Our standard Gimi indices, which include large- and mid-cap securities, should have 85% of the market capitalisation of the particular market. This is a very different construction from other indices.
"Within our non-custom index range, we also provide some market neutral benchmarks, but have generally focussed on indices which represent a market or an idea very well, and are less focused on the investment instrument which is directly or indirectly linked to it," said Stoof. "That partly explains why some other indices have been chosen for structured products, rather than MSCI.
"That said, we are doing a lot to change," said Stoof. "We are the leading provider when it comes to ESG, by the number of indexes, or by assets under management linked to our ESG indices."
Environment, social and governance are grouped together because there is a non-financial consideration, according to Christine Chardonnens (pictured), executive director at MSCI.
"ESG is a relatively broad term, and there may be a separation of these elements," said Stoof. "The United Nations Environment Programme Finance Initiative, aiming to define ESG in 2010, concluded that there is no clear definition, but mentioned that the term is used to summarise issues which have traditionally been seen as non-financial or non-material, have a medium- or long-term impact and are normally associated with externalities. More and more, people realise that there is a financial impact, as the data becomes more transparent, available, gathered and analysed.
"Further ESG related regulation contributes to this: there can be a downside with companies which break a specific rule because the governance structure is not good, the investor faces a risk that can be financially relevant."
"The ESG ratings are produced by MSCI Research, which has 160 ESG research analysts rating companies: these ratings and other ESG data points provided are used as the input for our indices.
The index company calculates over 100 ESG indices with different focus on risk mitigation, such as the World ESG Index, on value alignment, the World SRI Index, impact and environment, the ACWI Sustainable Impact, or the Low Carbon Leaders indices.
"The methodology for the index calculation is clearly defined, publically available and there is no committee which influences the composition of a custom index. For example, the World ESG Index companies are only included if they have an MSCI ESG ratings and a score on the ESG Controversy Scale," said Stoof. "A portfolio or index optimisation is then performed to ensure the maximum exposure to highly ESG-rated securities. Generally, it becomes an index which has the characteristics of a benchmark representing the market with an ESG value element.
"So, most of our indices are generally neutral for whatever investment products the investor would like to use, whereas our custom indexes can be designed to, for example, have higher dividend yields, or lower volatilities than market benchmarks. This can be achieved by using our index methodologies, eg. the Minimum Volatility Optimisation, or custom methodologies." he said. "The investor has to accept that he has to actively choose the financial product, but also the index which underlies that product."
"Companies can be systematically filtered on a high level using their ESG rating, on a score or descriptor level, such as positive or negative exclusion because of particular business activities," said Stoof."These criteria can be combined to create indices which are not only aligned with one of the three approaches to ESG investing - risk mitigation, value alignment and impact - but accomplish several of them together, for example the MSCI World SRI Index uses screens for ESG ratings and Controversies, but also filters out companies which generate revenue from specific activities - thus, it reduces ESG-related risk, but also aligns with a value-based investment philosophy," said Stoof.
"The SRI and ESG index series are the broadest categories, using ESG ratings plus other criteria. SRI is a little narrower than ESG and includes unethical activities, which is where the social conscience element comes in," said Stoof. "Companies in the SRI Index have to have a higher rating, and some other criteria are stricter."
Then there are indices which address one of the E, S and G elements more specifically. The Low Carbon Target and Leaders Index series addresses the need to reduce exposure to carbon emitting companies and aim to provide an adequate benchmark for the low-carbon investing. "The ACWI Sustainable Impact Index searches out companies aligned with UN Sustainable Development goals; the Environmental Index searches out companies that produce environmental technology, such as for water," said Stoof.
"It seems that there is sometimes still confusion between the terms ESG and Environment," sai Stoof. "The difference is that Environmental investing is a sub-category of ESG. An ESG approach from the perspective of an institutional investor, ie. the integration of ESG criteria into the investment process, is often based on risk mitigation and thus uses ratings and controversies screens, thus Environmental criteria are an essential part of this assessment.
"If implemented on its own, an index focussing only on Environmental issues can either follow a risk-based approach by taking into account Environmental risks or one Environmental risk, such as carbon emissions," he said. Or the index can be constructed to help to implement an impact investing approach, eg. by screening for companies which provide a product or service to address a specific environmental threat.
"These indices, because of their criteria, become smaller, which has an effect on their tradability," said Stoof. "It can also mean that the companies are more focused and, therefore, smaller.
"For all custom and non-custom indices, we provide details on the investability of an index, showing, say, how much will be rolled every quarter and on an annual basis," he said. "The narrower the index becomes, the more it rolls. That might mean it's more costly to replicate the index with whatever investment there is."
There is US$68bn tracking MSCI ESG indexes, either invested via an investment instrument, like ETFs, or tracking the benchmark.
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