MSCI index launches ESG into mainstream

Following its merger with RiskMetrics, global index provider MSCI will launch a series of indexes and risk products incorporating ESG for the first time, and in doing so will propel ESG factors into the mainstream. Amanda White spoke to managing director, global head of index and applied research at MSCI, Remy Briand.

With more than 120,000 indexes and 2,400 organisations subscribing to its equity index products, MSCI can reasonably argue its status as the most widely-used provider of global equity benchmarks by institutional investors.

With this in mind the decision to launch a number of ESG index and risk products in September is a revolution for the industry which has supported the need to understand the concepts, risks and opportunities of ESG, but struggled to incorporate it into investment processes.

Managing director, global head of index and applied research at MSCI, Remy Briand, acknowledges that incorporating ESG factors provides some unique challenges.

“We’re going to discuss with clients, why would you incorporate ESG, and our view is that for asset owners ESG is taking into account externalities generated by companies which may affect the whole portfolio – traditional finance looks at companies in isolation. It is interesting for pension funds to look at those negative externalities,” he said.

“It’s an area that is difficult to measure sometimes but this year there’s been a number of very high profile cases such as FoxConn and BP which have been great examples.”

MSCI is working on an “extensive lineup” of indexes that will incorporate ESG, including country and industry indexes, as well as some specific indexes that cover SRI or the environment more specifically, and all will adopt the best-in-class methodology.

MSCI is also currently under way into how to include companies’ carbon footprints into an index, which will be done by adjusting the weights of companies in the index according to their carbon footprint.

The genesis for the ESG indexes comes from MSCI’s acquisition of RiskMetrics which was completed in June.

The RiskMetrics stable includes a wealth of ESG-related businesses including: Institutional Shareholders Services, the proxy voting service bought by RiskMetrics in 2007; Innovest Strategic Value Advisors which specialises in analysing companies’ performance on ESG factors groups and was bought in February 2009; and KLD which published the first research designed to evaluate the risks and opportunities associated with corporate social and environmental performance and was bought as recently in November 2009.

Of the top 50 institutional money managers worldwide, about 30 use KLD’s research to integrate ESG into their investment decisions. And the KLD 400 index, launched in May 1990 as the Domini 400 Social Index was the world’s first benchmark index built using ESG factors. MSCI will incorporate the history of that index into its new series.

(The suite of KLD indexes is currently calculated and licensed by FTSE).

With a rebranding, and a tweaking of the underlying core index to be consistent with the MSCI methodology, existing clients will be transitioned to the new index by the end of August.

“We plan to change the underlying index so that is consistent with the other MSCI indexes. It will use the best in class methodology, and the parent index will be an MSCI one, they will be part of the family and use the same criteria,” Briand said. “As far as ESG factors, we want to leverage the wealth of knowledge, experience and research of the existing ESG research group. RiskMetrics has built a very large research organisation and (has) about 60 people in ESG research.”

Briand says the best in class notion is defined by targeting 50 per cent of market cap by sector – and includes those with the highest ESG rating.

“The structure of each sector which will dictate how many stocks are included, but we are targeting 50 per cent. The major indexes will be the best-in-class, we will change some aspects of the methodology, but it is more of an evolution than strict criteria at the outset,” Briand says. “The timing will be to transition existing clients by the end of August which is when the quarterly rebalancing at MSCI is conducted, and from September 1 all those clients will have transitioned and we will then have a formal announcement.”

He says there has definitely been an increasing demand in ESG in general, and in particular MSCI sees a trend to integrate ESG into the mainstream investment process, rather than as a separate product. And, importantly, according to the data (see performance figures in the graph below) there is a performance pay-off as well.

“From that perspective for us we want to provide clear ratings and benchmarks to reflect those ratings, so there is alignment with the methodology of the rating and a benchmark.”

One of the benefits of bringing the indexes into the MSCI fold is that a direct comparison will be possible with the general index used by most institutional investors.

“We don’t have a direct comparison, but will be able to do that relatively easily when we have both series,” he says. “One thing we are communicating is that the ESG dimension takes into account aspects that may have a long-term effect and the stock market is discounting short-term factors. And this has performance analysis considerations for institutional investors.”

MSCI is also considering incorporating ESG factors into its risk products.

“It is definitely worth investigating and we are looking at it with Barra but it is at a very early stage,” he said.

Source: FactSet Research Systems, Inc, FTSE Group, MSCI

MSCI Global Investable Market Indices Methodology (pdf)