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Laura Nishikawa

Laura Nishikawa
Head of Fixed Income in ESG Research

How to integrate ESG without sacrificing diversification

As institutional equity investors increasingly think about the long term, they may adjust their portfolios to accommodate environmental, social and governance (ESG) concerns in their investment decision-making processes. That can be particularly challenging for the largest investors, such as pension funds and endowments, whose portfolios span the entire equity market.

Excluding every objectionable firm in a benchmark index or selecting only ESG leaders can slash the number of acceptable stocks by up to half. What’s more, excluding companies altogether precludes opportunities for dialogue and engagement. So how does a large asset owner implement ESG principles without sacrificing diversification or abandoning efforts to improve corporate conduct?

One way is to increase the weightings of companies with robust ESG profiles, including those that show improvement in the direction of their rating over the most recent 12 months, while minimizing exclusions to a core group of objectionable stocks. This approach can enable investment in a broad, diversified stock universe while still allowing institutional investors to engage poor ESG performers.

The first challenge is establishing a core set of excluded stocks. After consulting large asset owners, we identified consensus around excluding only the worst ESG performers, as defined by their involvement in controversial weapons (cluster munitions, landmines, biological and chemical weapons), and violations of international norms.

The second challenge is weighting the remaining stocks. As noted, the MSCI ESG Universal Index, designed to represent the performance of such a strategy, tilts weights toward companies that have a strong current ESG profile or are improving their ESG performance.

Backtested performance of the MSCI ESG Universal Index, while not indicative of future results, showed superior risk-return characteristics with a 1% tracking error (the degree to which a portfolio’s performance deviates from its parent index). As shown in the charts below, the ESG Universal Index outperformed the MSCI ACWI Index (which represents 46 developed and emerging markets) by an annual average of 0.20 percentage points (hundredths of a percentage point) over a seven-year simulated period with a slightly lower level of ESG risk.¹

 

The MSCI ACWI ESG Universal Index outperformed the MSCI ACWI Index in a backtested simulation

Source: MSCI

 

Source: MSCI

 

This approach also produced an ESG profile superior to the index’s parent benchmark, suggesting that it could serve large asset owners seeking to implement an investment strategy in accord with their ESG goals.

 

¹Backtested performance is not actual performance, but is hypothetical. There are frequently material differences between backtested performance results and actual results subsequently achieved by any investment strategy. Such results are not indicative of future results or performance, which may also differ materially. 

 

Further reading:

Keep it Broad: An Approach to ESG Strategic Tilting

Integrating ESG into Factor Portfolios

Can ESG Add Alpha?

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