INDEX METHODOLOGYMSCI GOVERNANCEQUALITY INDEXESMETHODOLOGY
Mrig, Lokesh

June 2015

JUNE 2015

MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

CONTENTS

1Introduction ................................................................................ 3

2

Index Construction Methodology ................................................ 43

2.1

Applicable Universe.................................................................................. 4

2.2

Determination of Quality Score ............................................................... 4

2.3

Determination of Governance Score ....................................................... 4

2.3.1

Governance Measures ......................................................................................4

2.3.2

Governance Measures included in The methodology ......................................4

2.3.3

Securities not covered by MSCI ESG governancemetrics .................................5

2.3.4

Calculation of The Governance Score ...............................................................5

2.4

Determination of Composite Quality Score ............................................. 6

2.5

Security Selection ..................................................................................... 6

2.6

Weighting Scheme ................................................................................... 6

Maintaining MSCI Governance-Quality Indexes .......................... 7
3.1

Semi-Annual Index Reviews ..................................................................... 7

3.2

Buffer Rules .............................................................................................. 7

3.3

Ongoing Event Related Changes .............................................................. 7

3.3.1

IPOs and other early inclusions .........................................................................7

3.3.2

Additions and Deletions due to corporate events ............................................8

3.3.3

Deletions Between Semi-Annual Index Reviews ..............................................8

Appendix I: Description of quality score............................................. 9
Appendix II: Governance Measures in methodology........................ 10
Appendix III: Rules to Determine Fixed Number of Securities at Initial
Construction and in Ongoing Rebalancing ....................................... 11
Appendix IV: Corporate Events Treatment ....................................... 14© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

1

INTRODUCTION
The MSCI Governance-Quality Indexes aim to reflect the performance of a strategy that isseeking to capture both the financial and corporate governance aspects of Quality investing.
Institutional investors worldwide are adopting stewardship codes and increasingly lookbeyond financial data to assess the quality of the companies they invest in. Many investors
believe that investing in quality growth companies with good governance practices is key togenerating long term sustainable investment returns and improve downside risk protection.
The financial aspects of the Quality factor are captured using the same fundamental data as
used in the MSCI Quality Index – return on equity, financial leverage and earnings variability.
The standard of corporate governance is measured through measures such as independence
and diversity of board of directors, ownership and control structure of the company,
accounting practices and auditor opinions. The measure of corporate governance is thenused to discount security’s financial quality score.

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2

INDEX CONSTRUCTION METHODOLOGY

2.1

APPLICABLE UNIVERSE
The applicable universe includes all the existing constituents of an underlying MSCI index(herein, a “Parent Index”). This approach aims to provide an opportunity set with sufficientliquidity and capacity. The relevant MSCI Parent Index would be any Country or Regional
market cap weighted Index.

2.2

DETERMINATION OF QUALITY SCORE
The quality score for each security in the Parent Index is calculated as per the standard
methodology of MSCI Quality Indexes. (Please see Appendix I for a brief description of
Quality score, for detailed description please refer to MSCI Quality Indexes Methodology on
https://www.msci.com/index-methodology)

2.3

DETERMINATION OF GOVERNANCE SCORE
A governance score for each security in the Parent Index is calculated by combining 11
governance measures.

2.3.1

GOVERNANCE MEASURES
Governance keymetric scores are published by MSCI ESG Research as part of MSCI ESG
Governance Metrics research. MSCI ESG Research generates 96 Key Metrics to facilitatecompany assessment from a corporate governance perspective. Each keymetric reflects a
simple pass/fail evaluation of the company on a particular dimension. Depending on the
research evaluation, a company is assigned a score of 0(pass)/1(fail) on each of the 96 Key
Metrics. The governance measures used in the construction of this index are based on asingle key metric as well as combinations of Key Metrics (as detailed below and in Appendix
II).

2.3.2

GOVERNANCE MEASURES INCLUDED IN THE METHODOLOGYThe Governance-Quality index methodology includes 17 of the 96 Key Metrics published by
MSCI ESG Research. Six Key Metrics related to equal shareholder voting rights are combined
into one measure which we label ‘One Share One Vote’ and two Key Metrics related to the
independence of the board chair are combined into one measure called ‘Independent Chair’.
For these two measures, if any component Key Metric has a score of one then the combined
score governance measure is 1. See Appendix II for a complete list of governance measures,
the Key Metrics they depend on and their full description. Measure selection was based on
the following criteria:

Relevance – Measures chosen should be those generally considered to beimportant by investors as part of an assessment of corporate governance.

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2.3.3



Objective – Measures chosen should be able to be assessed objectively, beeasily understood and be directly related to corporate governance.



Differentiating – Measures should differentiate companies in the global covered
universe i.e., a meaningful proportion of companies have scored 1 and 0 in theuniverse (“qualified auditor opinion” is an exception to this because of its
nature).



Universal – Measures which are relevant and applicable to companies globally

Coverage – Measures for which MSCI ESG global data coverage is excellent.

SECURITIES NOT COVERED BY MSCI ESG GOVERNANCEMETRICS
When a security in the Parent Index is not covered by ESG Governance Metrics data, then all
Key Metric scores of that security are updated with the relevant country mode for each Key
Metric score. For example, if a UK company is not covered in the MSCI ESG GovernanceMetrics data then the company’s Key Metric scores are taken to be mode Key Metric scoresof all other UK securities with complete data. If the only company from a country is notcovered in the Governance Metrics data then the company’s keymetric scores are taken to
be mode keymetric scores of all other securities in the universe with complete data.

2.3.4

CALCULATION OF THE GOVERNANCE SCORE
The governance score is calculated on a scale of 0 to 1, such that the scores increase withincreasing standards of corporate governance. The metric ‘Qualified Auditor Opinion’ is used
as a discount factor for the overall governance score: if there is a 1 assigned as the score for“Qualified Auditor Opinion” then the governance score of the company is halved. For eachsecurity in the Parent Index, a governance score is calculated as below.
Governance Score = [1 – Average (10 governance measures included in methodology)] * (10.5* Qualified Auditor Opinion score]
For example, if a company failed the evaluation on six metrics
Average of 10 Key Metrics = (6*1)/10 = 0.6



Subtract from 1 to create discount factor = 1- 0.6 = 0.4

Suppose “Qualified Auditor Opinion” score = 0oGovernance score = [1-0.6]*(1-0.5*0) = 0.4

However, if the “Qualified Auditor Opinion” score = 1

o Governance score = [1-0.6]*(1-0.5*1) = 0.2© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

2.4

DETERMINATION OF COMPOSITE QUALITY SCORE
The “Composite Quality” score combines quality score and governance score and penalizes
the quality score with a discount factor if the company does not pass the test on all 11
governance measures. The “Composite Quality” score is calculated as below
Composite Quality Score = Quality Score * Governance Score
As the governance score ranges between 0 and 1, the governance score acts as a discount tosecurity’s quality score. For example, if a company fails the test on only one governancemetric, its financial quality score is discounted by a factor of 0.9.

2.5

SECURITY SELECTION
The MSCI Governance-Quality Index is constructed using a fixed number of securities
approach. All the existing constituents of the relevant MSCI Parent Index are ranked basedon their Composite Quality Scores. If multiple securities have the same Composite Quality
Score, then the security with the higher weight in the Parent Index is given a higher rank. A
fixed number of securities with the highest Composite Quality Scores are predetermined forevery MSCI Governance-Quality Index at initial construction with an aim to attain a highexposure to the Composite Quality factor while maintaining sufficient index market
capitalization and number of securities coverage. Rules for arriving at a fixed number of
constituents at initial construction are explained in Appendix III. The fixed number for
security selection determined at initial construction is evaluated at every Semi-Annual Index
Review (SAIR) to ensure that the Governance-Quality universe has sufficient index market
capitalization coverage. Rules for evaluating the fixed number of constituents at every SAIR
are explained in Appendix III.

2.6

WEIGHTING SCHEME
At each rebalancing, all the securities eligible for inclusion in the MSCI Governance-Quality
Indexes are weighted by the product of their market capitalization weight in the Parent
Index and the Composite Quality Score.
Governance-Quality Weight = Composite Quality Score * Market Capitalization Weight in
the Parent Index
The above weights are then normalized to 100%.
Additionally, constituent weights are capped at issuer level to mitigate concentration risk:
1. Issuers in the MSCI Governance-Quality Indexes based on broad Parent Indexes (e.g.
MSCI World Index) will be capped at 5%
2. Issuers in the MSCI Governance-Quality Indexes based on narrow Parent Indexes will becapped at the maximum weight in the Parent Index.
Narrow Parent Indexes are defined as those indexes for which the maximum market
capitalization weight in the Parent Index is more than 10%.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

3

MAINTAINING MSCI GOVERNANCE-QUALITY INDEXES

3.1

SEMI-ANNUAL INDEX REVIEWSThe MSCI Governance-Quality Indexes are rebalanced on a semi-annual basis, usually as of
the close of the last business day of May and November, coinciding with the May andNovember Semi-Annual Index Review of the MSCI Global Investable Market Indexes. Bothquality scores and governance metric scores as of the end of April and October are used
respectively. This approach aims to capture timely updates to Governance-Quality
characteristics of the companies and coincides with the rebalancing of the relevant MSCI
Parent Indexes. The pro forma MSCI Governance-Quality Indexes are in general announced
nine business days before the effective date.
At each rebalancing, a constraint factor is calculated for each constituent in the MSCI
Governance-Quality Index. The constraint factor is defined as the weight in the MSCI
Governance-Quality Index at the time of the rebalancing divided by the weight in the Parent
Index.

3.2

BUFFER RULES
To reduce Index turnover and enhance Index stability, buffer rules are applied at 20% of the
fixed number of securities in the MSCI Governance-Quality Index.
For example, the MSCI World Governance-Quality Index targets 300 securities and thebuffers are applied between rank 241 and 360. The securities in the MSCI Parent Index witha Composite Quality score rank at or above 240 will be added to the MSCI World
Governance-Quality Index on a priority basis. The existing constituents that have a
Composite Quality score rank between 241 and 360 are then successively added until thenumber of securities in the MSCI World Governance-Quality Index reaches 300. If thenumber of securities is below 300 after this step, the remaining securities in the Parent
Index with the highest Composite Quality Score rank are added until the number of
securities in the MSCI World Governance-Quality Index reaches 300.

3.3

ONGOING EVENT RELATED CHANGESIn general, the MSCI Governance-Quality Indexes follow the event maintenance of the MSCI
Parent Index.

3.3.1

IPOS AND OTHER EARLY INCLUSIONS
IPOs and other newly listed securities will only be considered for inclusion at the next SemiAnnual Index Review in the MSCI Governance-Quality Index, even if they qualify for early
inclusion in the MSCI Parent Index.

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3.3.2

ADDITIONS AND DELETIONS DUE TO CORPORATE EVENTS
The general treatment of additions and deletions due to corporate events aims to minimize
the turnover in the MSCI Governance-Quality Indexes. A constituent deleted from the MSCI
Parent Index following a corporate event or during the Quarterly Index Review of the Parent
Index will be simultaneously deleted from the MSCI Governance-Quality Index.
Please refer to Appendix IV for more details on the treatment of corporate events.

3.3.3

DELETIONS BETWEEN SEMI-ANNUAL INDEX REVIEWS
In exceptional circumstances, a security may be deleted from an MSCI Composite Quality
Index if there is a very substantial deterioration of their governance assessment and ratings
according to MSCI ESG Research.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

APPENDIX I: DESCRIPTION OF QUALITY SCORE
The quality score for each security is calculated by combining the z-scores of threefundamental descriptors, Return on Equity, Debt to Equity and Earnings Variability. A given
variable z-score for a security is calculated using the mean and standard deviation of thecorresponding variable computed within the MSCI Parent Index. After calculating
component variable z-scores, a composite z-score for each security is computed by taking anequal-weighted average of the component z-scores. The Quality Score is then computedfrom the composite Z score as follows:

Quality Score =1+Z, 𝑍 >01 − Z −1 , 𝑍 < 0

Where Z is the composite Z score described earlier.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

APPENDIX II: GOVERNANCE MEASURES IN METHODOLOGY#

Metric Name

GovernanceMetrics Pillar

Default
Score*(Fail=1/
Pass =0)

Description

1

Qualified Auditor
OpinionAccounting

0

2

Audit Committee
Independence

Board

1

3

Board Attendance
FailureBoard0

Has the company's independent auditor
expresses a qualified opinion, or
questioned the company's ability toremain a going concern?
Does the company have an audit
committee comprising only members
who meet the criteria of independence?
Did all members attend at least 75% of
all board and committee meetings?

4Comp Committee
Independence

Board

1

5

Gender Diversity

Board

1

6

Independent Board
MajorityBoard

1

Do a majority of the directors meet thedesignated criteria for independence?

7

Independent Chair**

Board

0

Does the board have an independent
chair?

8

Annual Director
Elections

Ownership andControl0

Do all directors stand for annual reelection?

9

Cross Shareholding

Ownership andControl

010

One Share One Vote
(OSOV)***

Ownership andControl0

Is the company involved in a series ofcross-shareholdings with other ( relatedor unrelated ) companies
Do all shares have equal voting rights?

11

Poison Pill

Ownership andControl0

Are all comp committee members' nonexec directors who meet the MSCI ESG
Governance Metric criteria for
independence?
Does the board have at least one female
director?

Has the company adopted a shareholder
rights plan ("poison pill")* The score implicitly assigned to a company by MSCI Governance Metrics methodology
applied to Key Metrics in absence of sufficient data to conclude otherwise.
** Independent Chair: – combines 1) “Combined CEO/Chair” and 2) “Independent chair”*** OSOV (One Share One Vote)– combines (1) Multiple equity classes with differential
voting rights, (2) Golden shares, (3) Voting rights limits shares held, (4) Voting rights limits
residency, (5) Voting rights limits duration, (6) Voting rights limits min holding period.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

APPENDIX III: RULES TO DETERMINE FIXED NUMBER OF SECURITIESAT INITIAL CONSTRUCTION AND IN ONGOING REBALANCING
Algorithm to Determine Fixed Number of Securities at Initial Construction© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

Rounding Off Rules:
Upward rounding off is done depending on NumSec Obtained in the Previous Box Step
If NumSec in Previous Step < 100, Nearest Rounding = 10 Securities
If NumSec in Previous Step > = 100 but < 300, Nearest Rounding = 25 Securities
If NumSec in Previous Step >= 300, Nearest Rounding = 50 Securities© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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Algorithm to reevaluate Fixed Number of Securities at Semi Annual Rebalancing© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

APPENDIX IV: CORPORATE EVENTS TREATMENT
This appendix describes the treatment of the most common corporate events in the MSCI
Indexes. Details regarding the treatment of all other corporate events not covered in thisappendix can be found in the MSCI Corporate Events Methodology book, available athttps://www.msci.com/index-methodology

Event TypeAcquisition

MergerEvent details

ActionGovernance-Quality Index
constituent acquires another
Governance-Quality Index
constituent

Maintain acquiring
company and remove
acquired company

Governance-Quality Index
constituent acquires non
Governance-Quality Index
constituent

Maintain acquiring
company

Non Governance-Quality Index
constituent acquires GovernanceQuality Index constituent

Remove acquiredcompany without adding
acquiring company

Governance-Quality Index
constituent merges with
Governance-Quality Index
constituent

Add new company with aconstraint factor that is
the weighted average ofthe two constituents

Governance-Quality Index
constituent merges with nonGovernance-Quality Index
constituent

Add new company if MSCI
links its price history to
the Governance-Quality
Index constituent. New
company not added if
price history is linked to
the non- GovernanceQuality Index constituent

IPO added to Parent Index

Security will beconsidered for inclusion in
the Governance-Quality
index at the next SAIR

IPO

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MSCI GOVERNANCE-QUALITY INDEXES METHODOLOGY | JUNE 2015

Event TypeEvent details

ActionGovernance-Quality Index
constituent spins off security

Add spun-off security to
the Governance-Quality
Index with the constraint
factor of the spinningsecurity, if it is included in
the Parent Index

Conversion

Security A converted to B, A deleted
from Parent Index, B added

B inherits constraint
factors from A

Country
Reclassification

Domicile of company reviewed:
Security A deleted from country A,
security B added to country B

B inherits constraint
factors from A if it isadded to the Parent Index

Stock exchange
reclassification

Stock exchange (price source) ofcompany reviewed: Security A
deleted, security B added

B inherits constraint
factors from A if it isadded to the Parent Index

Other EventsResulting in Changes
in Number of Sharesand FIFs

Changes in number of shares andsubsequent FIF resulting from otherevents such as share placements
and offerings, and debt-to-equityswaps

No change in Constraint
FactorSpin-off© 2015 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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