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Jean-Maurice Ladure

Jean-Maurice Ladure

Executive Director, MSCI Research

Ashish Lodh

Ashish Lodh

Executive Director, MSCI Research

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An ‘ESG-First’ Approach to Portfolio Construction


  • Investor demand is rising for strategies that integrate environmental, social or governance (ESG) considerations with financial objectives.
  • Multi-asset-class portfolios can now be transformed through an ESG-first approach, with the capability of core, impact and tactical allocations.
  • Taking such an approach using MSCI solutions meaningfully improved the ESG characteristics of a hypothetical portfolio without significantly altering the risk-return profile.

The new Biden administration in the U.S. and ESG-related disclosure regulations and guidelines slated to take effect across Europe will likely increase investors’ focus on sustainability. We’ve seen already, however, that to help counter the effects of climate change or reallocate capital to companies that contribute to positive environmental, social or governance outcomes, investors have increasingly pursued strategies that unite financial objectives with ESG considerations.

How could an “ESG-first” portfolio take shape? 

Leading with ESG

We can examine an approach to integrating measurable ESG and climate considerations with financial objectives into hypothetical portfolios. This ESG-first approach can comprise three components:

1. A core allocation to a mix of equities and bonds that broadly integrates ESG and climate considerations

2. An impact allocation to a mix of assets that reflects the investor’s specific ESG preferences

3. A tactical allocation that includes decisions around other considerations, including regions, sectors, style factors, durations, credit ratings or currencies


Transforming a Portfolio Through an ESG-First Approach



Starting with a Solid Core

The foundation of the framework proposed here rests on the core allocation, which aims to deepen the integration of ESG without disturbing the risk-return trade-off. It can be incorporated early in the investment process, at the benchmark or strategic asset-allocation level, by substituting ESG equity and fixed-income benchmarks (such as the MSCI ACWI ESG Leaders Index and the Bloomberg Barclays MSCI Global Aggregate Sustainability Index) for their standard market-capitalization-weighted counterparts.1

Such a substitution improved the MSCI ESG Rating of our hypothetical portfolio to “leader” (AA) from “average” (A), raised its ESG score by 13%, cut overall carbon intensity (Scope 1 and 2 emissions) by almost 10% and increased the green-to-fossil-fuel-revenues ratio by more than 50%.2 Over the back-test period, the trade-off between risk and return was almost unchanged, with the core allocation marginally reducing risk, by 30 basis points (bps), and slightly improving performance (20 bps), with low tracking error (70 bps).3


Better Sustainability with Low Tracking Error


Having an Impact

The impact component of the ESG-first hypothetical portfolio contains a mix of equity and fixed-income holdings that aim to translate investor preferences into corresponding investment solutions.

The impact allocation may include investments that target one or more of the U.N. Sustainable Development Goals (SDGs), such as gender equality or climate action, as reflected in a company’s products and operations. To help fine-tune allocations with the goal of maximizing impact, investors may look to tools such as MSCI’s SDG Alignment Tool, which assesses the alignment of about 8,500 companies around the world with each of the SDGs. The impact allocation may also look to track so-called megatrends, such as smart cities, or include green bonds issued by companies that earn a significant share of revenue from alternative energy or green buildings.

Moving to an ESG-First Portfolio

The final component of the three-part portfolio construction process aims to preserve the manager’s ability to make tactical calls across regions, sectors, style factors, durations, credit ratings or currencies as they manage portfoliowide financial exposures. The performance of many of those decisions can be represented via indexes designed to reflect a specific strategy and integrate ESG norms.

The exhibit below uses indexes as proxies to illustrate a hypothetical ESG-first portfolio that includes all three components. The core objective remains ESG improvement with a focus on climate risk. The impact allocation expresses the investor’s personal preferences such as environmental issues and gender diversity. The tactical portion leaves room for specific investment calls.


Anatomy of an ESG-First Portfolio

Core   Core Allocation 60%


 Core Objectives 


Fixed Income Bbg Barclays MSCI Global Agg. Sustainability Index 12.0%  
  • Carbon Exposure Reduction
Bbg Barclays MSCI Global Agg. SRI Index 12.0%  
Equities  MSCI ACWI ESG Focus Index 6.0%
  • Carbon Exposure Reduction
MSCI ACWI SRI Index 18.0%  
MSCI ACWI Low Carbon Target Index 9.0%  
  • Low Carbon Transition Risk Management
MSCI ACWI Climate Change Index 3.0%  
Impact  Impact Allocation 20%    Personal Preferences 


Fixed Income  Bbg Barclays MSCI Euro Green Bond Index 5.0%  

  • Environment (Pollution, Green Building)


MSCI Global Energy Efficiency Index 3.0%  
MSCI Global Green Building Index 3.0%  
MSCI Global Pollution Prevention Index 1.5%  
  • Gender Diversity


MSCI ACWI Sustainable Impact Index 3.0%  
MSCI World Womens Leadership Index 1.5%  
  • Making Cities Sustainable
MSCI ACWI IMI Future Mobility Index 3.0%  
Tactical  Tactical Allocation 20%    


Fixe Income  MSCI USD IG ESG Leaders Corp Bond Index 5.0%    
Bbg Barclays MSCI Euro Long Corp Sustainability Index 2.0%    
Bbg Barclays MSCI GBP Int Corp Sustainability Index 1.0%    
Equities  MSCI USA SRI Index 6.0%    
MSCI Europe SRI Index 3.0%    
MSCI Japan SRI Index 1.8%    
MSCI EM SRI Index 0.6%    
MSCI China ESG Leaders Index 0.6%    



The hypothetical ESG-first portfolio is designed to enhance the investor’s objectives. As the exhibit below shows, the three steps of the portfolio allocation process, taken together, improved the MSCI ESG Rating to “leader” (AA), brought the total improvement in its ESG score to 15%, cut its carbon footprint (Scope 1 and 2 emissions) by 30% and enhanced the portfolio’s green-to-fossil-fuel-revenues ratio 5.6 times, compared with the market-cap benchmark.6


Enhanced ESG and Climate Objectives

Data from Dec. 30, 2016, to April 30, 2020


The portfolio also added 1.5% of annualized active return over the back-test period, with a tracking error of 1%. While picking up a bit more volatility due to the slight equity overweight, it achieved a better risk-return trade-off overall.

The outperformance of the equity portion of the portfolio can be mostly attributed to a combination of ESG, quality and low-volatility factors (+50 bps, +30 bps and +20 bps, respectively), as well as sector exposures, such as an underweight to energy.7 It should be noted that the back-test period included the first months of the COVID-19 crisis, through April 2020.


Illuminating ESG Characteristics

To help assess how an ESG-first portfolio aligns with their preferences, investors can use tools, such as those from MSCI, to deconstruct and display the portfolio’s ESG characteristics and performance against the benchmark. That may include visualizing the impact of the portfolio for each set of environmental, social and governance factors, as well as tailoring the reporting to address unique preferences and the degree to which investments may align with the EU’s forthcoming standards for environmental sustainability.

While no one knows for sure where the new administration in the U.S., regulations in Europe or interest in ESG will lead, an ESG-first approach supports the integration of ESG and climate strategies into the investment process. It is one way to prepare for the effects of the reallocation of capital to ESG investments on the pricing of financial assets. It may also be an option for those who view the path to producing financial return as one and the same with the goal of a greener and more sustainable society.


1The indexes in this example may be used as a benchmark for performance measurement or by a portfolio manager seeking to replicate the index through investment in either funds tracking the index or the purchase and sale of individual securities.

2MSCI ESG Research rates companies on a scale from AAA (best) to CCC (worst), according to their exposure to ESG-related risks and how well they manage those risks relative to peers. Our ESG Ratings range from leader (AAA, AA) to average (A, BBB, BB) to laggard (B, CCC) and correspond to ESG Scores ranging from 10 (best) to 0 (worst). The green-to-fossil-fuel-revenues ratio is the ratio of the weighted average revenue from clean-technology solutions, or “green revenue,” to the weighted average fossil-fuel revenue defined as the weighted average percentage revenue derived from fossil-fuel-related activities — including thermal coal mining, oil and gas extraction, thermal coal-based power generation and oil- and gas-based power generation. Please see the Further Reading section at the end of this post for more information.

3The back-test covered the period from Oct. 31, 2013, through April 30, 2020.

4In 2015, the United Nations adopted 17 UN Sustainable Development Goals in an effort to end extreme poverty, reduce inequity and protect the planet by 2030. See “Transforming our World: the 2030 Agenda for Sustainable Development.” United Nations Department of Economic and Social Affairs, Oct. 21, 2015.

5The analysis and observations in this report are limited solely to the period of the relevant historical data, back-test or simulation. Past performance — whether actual, back-tested or simulated — is no indication or guarantee of future performance.

6Exposure to carbon-intensive companies is based on Scope 1 and Scope 2 emissions. Equity and fixed-income (ex-sovereign bonds/Treasurys) in tons of CO2/USD million of sales, fixed-income sovereign/Treasurys in tons of CO2/ million USD of GDP nominal.

7For the attribution, we use MSCI’s Global Total Market Equity Model (GEM), which also includes ESG as a factor.


Further Reading

Assessing Company Alignment with UN SDGs

2021 ESG Trends to Watch

Is ESG Investing a Price Bubble? Probably Not.

MSCI ESG Ratings Methodology