FROM MSCI ESG RESEARCH LLC. CAN ESG ADD ALPHA: HIGHLIGHTS FROM MSCI RESEARCH April 25, 2017
AN IMPRACTICAL EXAMPLE OF ESG RESEARCH RATINGS 2
AGENDA • Background and methodology • Low-risk / passive investing findingslike size) • Factor investing findings • High-conviction investing findings • Conclusions 3
INTRODUCING MSCI 50 of the top 42 of the top 50 global 50 global asset managers asset owners 31 of the top 27 of the top 50 global 50 global hedge funds banks Sources: MSCI as of June 30, 2015 and P&I, aiCIO, Hedge Fund Intelligence and The Banker as of December 31, 2014 4
ESG PORTFOLIO INTEGRATION VALUES VALUE INTEGRATE RISKS ALIGN VALUES TARGET IMPACT Financial Returns Social Financial Financial Values & & Env Returns Preferences Returns Selected ESG Benefits Factors Align portfolio with Generate measureable Incorporate selected investor’s ethical or social or environmental factors to enhance long term return political values benefits 5
MSCI RESEARCH BUILDING BLOCKS Discretionary Insights on Sources of MSCI Risk and Return ESG Research BARRA Portfolio Construction Tools and Risk Models 6
METHODOLOGY: ESG RISK EXPOSURE AND MANAGEMENT Management Capacity Level of Exposure • Policies & commitments • Programs & initiatives • • Type of operations Performance indicators • Controversies • Location of operations • Size of operation, etc EVALUATE MANAGEMENT STRATEGY IN THE CONTEXT OF RISK EXPOSURE 7
BARRA RISK MODELS • Distinguish between COMMON drivers of risk and return across securities, called FACTORS, and stock-SPECIFIC effects • Provide a consistent framework for measuring and comparing the active bets that portfolios take against benchmarks, including • Style factors (characteristics like size) • Industry factors • Country factors 8
INSTITUTIONAL INVESTORS ALLOCATE TO FACTORS 1980s 2000s 1960s Discretionary Active Implementation Alpha Investing Active Active Return Return Factor Factor Portfolio Return Investing Return Transparent Implementation Market Market Passive Return Return Investing Market Return For a discussion of the role of factor investing in institutional portfolios, see “Power to the People: The Profound 9 Impact of Factor Investing on Long Term Portfolio Management”, Journal of Portfolio Management, Winter 2016
DISTRIBUTION OF ESG SCORES FOR MSCI WORLD 10
A. WHY ESG PASSIVE/LOW-RISK STRATEGIES? • Asset owners and passive asset managers may wish to incorporate ESG in their portfolios but may wonder to what extent ESG may impair their ability to capture broad market returns efficiently 11
A. INCORPORATING ESG INTO PASSIVE STRATEGIES Parameters Comments Universe MSCI World Index Maximize ESG Score subject to ex-ante active risk of 25, 50, 100, 200 Objective bps Target Factor ESG Score (0 to 10, industry adjusted) • Style factor exposures: unconstrained Exposure • Country & sector active weights: ± 5% Constraints • Maximum stock active weights: ± 2% Investability • Maximum stock inclusion factor: 10x Constraints • Quarterly rebalancing, turnover 5% 12
A. INCORPORATING ESG INTO PASSIVE STRATEGIES 13
B. COMMON FACTOR INVESTING BUCKETS VALUE SIZE MOMENTUM VOLATILITY QUALITY YIELD • Factors are stock characteristics that explain portfolio performance over long horizons • Factors are well documented in academic research and have been used extensively in portfolio risk models and in quantitative investment strategies. Active fund managers use these characteristics in their security selection and portfolio construction process • Factor indexes provide a transparent and efficient method to seek exposure to factors For further details on the rationale supporting factor investing and how indexes can be constructed to capture 14 these factor returns, see “Foundations of Factor Investing”, MSCI Research Insight, 2013, available on msci.com
B. FACTOR INVESTING FINDINGS • To quantify the potential impact of ESG integration on the ex- ante information ratio we focus on percentage reduction in target factor exposure . An x% drop in factor exposure due to an ESG constraint will translate into an x% reduction in ex-ante information ratio, everything else being equal TARGET FACTOR ESG SIGNAL 15
B. FACTOR INVESTING FINDINGS • Baseon factor 16
B. FACTOR INVESTING FINDINGS: MINIMUM VOLATILITY STRATEGIES • Baseon factor • Min vol strategies showed the most promising results 17
C. ACTIVE MANAGEMENT STRATEGIES • Approach Study higher risk strategies, i.e. allow higher active weights Deliberately treat ESG as a potential indicator of outperformance in portfolio construction • Strategy #1: ESG Tilt Best-in-class approach overweights higher-rated ESG companies, underweights lower-rated ones Explicitly improves ESG profile of portfolio Financial Rationale: Avoidance of future costs (e.g. liabilities) and more competitive positioning for market opportunities (e.g. future fuels) leads to outperformance in the long run 18
C. ACTIVE MANAGEMENT STRATEGIES • Strategy #2: ESG Momentum ‘Best - effort’ approach overweights companies with ESG ratings upgrades over the preceding 12-month period and underweights companies with ratings downgrades ESG profile of portfolio may or may not improve Financial Rationale: Assumes changes in how companies manage ESG issues are recognized by the market and future liabilities/growth are quickly discounted 19
C. STRATEGY #1: TILT PERFORMANCE 16% Source of Active Active Risk 14% Return Return (%) Contribution (%) 12% Style 0.76 0.00 Industry 0.08 0.21 10% Country -0.18 0.01 Currency -0.01 0.02 8% Specific 0.43 2.32 6% Total Active 1.06 2.55 4% • Risk dominated by stock-specific 2% sources 0% -2% • Large style return contribution, but -4% important specific as well Feb-07 Feb-09 Feb-11 Feb-13 Feb-15 Active Style Industry Country Currency Specific • Until 2013, specific return dominated 20
C. STRATEGY #2: MOMENTUM PERFORMANCE 30% Source of Active Active Risk Return Return (%) Contribution (%) 25% Style 0.72 0.08 Industry 0.44 0.35 20% Country -0.28 0.14 Currency 0.03 -0.05 Specific 1.32 2.07 15% Total Active 2.23 2.59 10% • Risk and return dominated by stock-specific sources 5% 0% • Important style and industry contributions to active return -5% Feb-08 Feb-10 Feb-12 Feb-14 • After 2012, industry and style Active Style Industry Country Currency Specific factors became significant 21
C. ACTIVE STRATEGY FINDINGS • In our backtest, it was possible to improve the ESG Rating and outperform a global benchmark * • The active risk of the strategies mainly arose from stock-specific sources as opposed to systematic sources • Active return came from specific and common factor sources • In the Tilt strategy, the stock-specific contribution was comparable to common factor contribution; in the Momentum strategy, it exceeded common factor contribution • Common factor contributions increased after 2012 * Future performance may differ materially 22
CONCLUSIONS • Our research across broad range of portfolio risk levels has found evidence of risk-adjusted value-add from ESG integration. • Multi-factor risk models provide a quantitative framework to evaluate and decompose the active risk and return that arise from ESG-oriented portfolios that deviate from assigned benchmarks • Our research in this area continues to evolve: Regional differences in ESG signal and portfolio construction More granularity of ESG scores (E or S or G stand-alone) Direct inclusion in Barra multi-factor risk models Longer backtests 23
CONTACT US AMERICAS + 1 212 804 5299 EUROPE, MIDDLE EAST & AFRICA + 44 20 7618 2510 ASIA PACIFIC + 612 9033 9339 msci.com/esg esgclientservice@msci.com 24
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