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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 exclusions¹ and minimum ESG standards² 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 score³
3. a reduction in carbon footprint⁴.

In essence, it is a multidimensional optimization problem. To help unpick things, I 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 red line represents the average (industry-adjusted) ESG score of 6.3, while the vertical red line represents the average value z-score by construction equal to 0.0.

Source: MSCI, ÃÛ¶¹ÊÓƵ Asset Management. Data as of December 2022 index rebalancing. For illustrative purposes only.

Two methods to create ESG factor portfolios

MSCI USA Prime Value ESG Low Carbon Select index

The MSCI USA Prime Value ESG LCS Index portfolio is indicated in Figure 1 with dark grey color; it includes 104 companies with an aggregate market cap weight of 17.0% versus 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 vs -0.13 , while it meets the ESG target improvement (+20%) and exceeds the carbon reduction target (-49%).

Performance

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 47 bps per annum, while the Quality ESG Index outperformed its standard factor equivalent by 72 bps per annum . 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, ÃÛ¶¹ÊÓƵ Asset Management. Data as of 31 July 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.

Optimizing appears optimal

Ultimately, historical simulations demonstrate that factor ESG solutions can be considered a good alternative to their traditional counterparts. And integrating ESG into factor indices can be achieved with an optimized approach that can efficiently balance between achieving factor exposures and sustainability objectives.

¹ For a more detailed discussion on this topic, we refer to MSCI publication ‘The MSCI Factor ESG Target Indexes’ (September 2017).
²This 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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