INDEX METHODOLOGYMSCI FACTOR ESG
TARGET SERIESINDEXESMETHODOLOGY
November 2017

NOVEMBER 2017

MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

CONTENTS

1Introduction ................................................................................ 32

ESG Research Framework............................................................ 43

Index Construction Methodology ................................................ 5
3.1

Eligible Universe ....................................................................................... 5

3.2

Constituent selection ............................................................................... 5

3.3

Weighting Scheme ................................................................................... 5

3.3.1

4

Calculation of the alpha score ..........................................................................5

3.4

Optimization Constraints ......................................................................... 6

3.5

Determining the optimized index ............................................................ 7

Maintaining the Indexes .............................................................. 8
4.1

Semi-Annual Index Reviews ..................................................................... 8

4.2

Quarterly Index Reviews .......................................................................... 8

4.3

Ongoing Event Related changes............................................................... 8

Appendix I: Handling Infeasible Optimizations ................................. 11
Appendix II: New release of Barra® Equity Model or Barra® Optimizer......................................................................................................... 12
Appendix III: Target Factor Definition Summary .............................. 13
Appendix IV: Controversy Score And Controversial Weapons
Exclusion Criteria ............................................................................. 15© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

1

INTRODUCTION
The MSCI Factor ESG Target Indexes are designed to represent the performance of astrategy that seeks systematic integration of environmental, social and governance (ESG)
norms in factor investing, by seeking higher exposure to a style factor or combination ofstyle factors along with the improvement in the ESG profile of the index.
MSCI categorizes the MSCI Factor ESG Target Indexes as part of the family of MSCI Factor
Indexes, which are designed to reflect the systematic elements of particular investment
styles or strategies. While capitalization weighted indexes aim to represent the broad
market beta, additional sources of systematic return associated with particular investment
styles and strategies, such as value, quality, volatility, etc. or their combination could be
represented through alternatively weighted indexes.
This index methodology aims to incorporate ESG-based constraints in a bottom-up factor
index construction1 approach.
The MSCI Factor ESG Target Indexes are constructed using individual stock exposures to thetarget factor/s along with specific ESG score criteria. The indexes aim to achieve relatively
high exposure to the target single/multiple style factor/s while improving the index’s ESG
profile relative to that of the underlying parent index by using risk-constrained optimization.
The index construction selects the final index by maximizing the exposure to the target
factor(s) less a penalty for the common factor and stock-specific risk characteristics of eachpotential constituent.

1

For the methodology of MSCI Minimum Volatility ESG Target Indexes please refer to MSCI Minimum Volatility ESG
Target Indexes methodology© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 20172

ESG RESEARCH FRAMEWORKMSCI ESG Research provides in-depth research, ratings and analysis of the environmental,social and governance-related business practices of thousands of companies worldwide. It
consists of an integrated suite of tools and products to efficiently manage research, analysis
and compliance tasks across the spectrum of ESG factors.
The MSCI Factor ESG Target Indexes use company ratings and research provided by MSCIESG Research. In particular, these indexes use the following three MSCI ESG Research
products: MSCI ESG Ratings Score, MSCI ESG Controversies Score, and MSCI ESG BusinessInvolvement Screening Research.
For details on MSCI ESG Research’s full suite of ESG products, please refer to:
http://www.msci.com/products/esg/about_msci_esg_research.html© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

3

INDEX CONSTRUCTION METHODOLOGY
The applicable universe includes all the existing constituents of an underlying MSCI parent
index (herein, the “Parent Index”). This approach aims to provide an opportunity set with
sufficient liquidity and capacity.
The MSCI Factor ESG Target Indexes (herein, “the Index”) are constructed based on an
optimization process from the underlying Parent Index using a Barra Equity Model tomaximize the index-level exposure to the targeted style factors while controlling tracking
error relative to the Parent Index. The optimization selects the final index by maximizing theexposure to the target factor(s) less a penalty for the common factor and stock-specific risk
characteristics of each potential constituent, as well as placing an upper bound on thepredicted tracking error of the index.
The steps for constructing the MSCI Factor ESG Target Indexes are described below.

3.1

ELIGIBLE UNIVERSE
The eligible universe is the universe of all the securities in the Parent Index that are not
involved in very severe ESG controversies (“Red flags”) or in controversial weapons. Moredetailed information about the ESG-based exclusions is provided in Appendix IV.

3.2

CONSTITUENT SELECTION
The selection of constituents from the applicable universe is done using the optimization
process.
The optimization relies on the factor exposures for all the securities in the Parent Index andthe factor covariance matrix of the relevant Barra Equity Model. The optimization is
performed using a base currency. The default currency is the US Dollar.

3.3

WEIGHTING SCHEME
The optimization objective is to maximize the alpha score (representative of the exposures
to the set of target factors), while controlling the ex-ante tracking error relative to the
Parent Index at the time of rebalancing.

3.3.1

CALCULATION OF THE ALPHA SCORE

3.3.1.1 Single Factor∝i = F1,i
Where,© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

𝑭𝒋,𝒊 = Factor exposure of each security i to the target factor.
The factor exposures for the target factors are sourced as described in Appendix III.
3.3.1.2 Factor Combination∝i = 𝑊1 ∗ F1,i + 𝑊2 ∗ F2,i + ⋯ + 𝑊𝑁 ∗ F𝑁,i
Where,
𝑭𝒋,𝒊 = Factor exposure of each security i to each of the target factor j.
N = Number of factors
𝑊1 = 𝑊2 = ⋯ = 𝑊𝑁 = 1/N
The factor exposures for the target factors are sourced as described in Appendix III.

3.4

OPTIMIZATION CONSTRAINTS
At each Semi-Annual Index Review (SAIR), the following optimization constraints are
employed, which aim to ensure investability while achieving improvement in ESG profile,
subject to tracking error constraint relative to the Parent Index.
The ex-ante tracking error of the Index, relative to the Parent Index will be capped at 3%



The weighted-average industry-adjusted ESG score of the Index portfolio will be at least
20% more than the weighted-average industry-adjusted ESG score of the Parent Index
portfolio

If the Parent Index is based on the Standard size-segment, the maximum weight of anindex constituent will be restricted to the lower of (the weight of the security in the
Parent Index + 2%) and 10 times the weight of the security in the Parent Index. The
minimum weight of an index constituent will be restricted to the higher of the (weightof the security in the Parent Index - 2%) and 0.



If the Parent Index is based on the Small Cap size-segment, the maximum weight of anindex constituent will be restricted to the lower of (the weight of the security in the
Parent Index + 1%) and 5 times the weight of the security in the Parent Index. The
minimum weight of an index constituent will be restricted to the higher of (the weightof the security in the Parent Index - 1%) and 0.

The exposure of the MSCI Factor ESG Target Index to the non-target Barra style factors(factors not included in the calculation of alpha score) will be restricted to +/-0.25
standard deviations relative to the Parent Index.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 20173.5

The sector weights of the MSCI Factor ESG Target Index will not deviate more than +/5% from the sector weights of the Parent Index.

For countries with weight greater than 2.5% in the Parent Index, the weight in the MSCI
Factor ESG Target Index will not deviate more than +/-5% from the country weight in
the Parent Index.

For countries with weight less than 2.5% in the Parent Index, the weight in the MSCI
Factor ESG Target Index will be capped at 3 times their weight in the Parent Index.

The one-way turnover of the MSCI Factor ESG Target Index is constrained to a maximumof 20% at each SAIR.

The common factor risk aversion parameter used in the optimization of the riskadjusted target factor exposure is 0.0015 and the specific risk aversion parameter is
0.015.

DETERMINING THE OPTIMIZED INDEXThe MSCI Factor ESG Target Index is constructed using the Barra Open Optimizer in
combination with the relevant Barra Equity Model2. The optimization uses the Parent Index
as the universe of eligible securities and the specified optimization objective and constraints
to determine the MSCI Factor ESG Target Index. Infeasible optimizations are handled as
explained in Appendix I.

2

Please refer to Appendix II for the detailed information on model usage© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

4

MAINTAINING THE INDEXES

4.1

SEMI-ANNUAL INDEX REVIEWSThe MSCI Factor ESG Target Indexes are rebalanced on a semi-annual basis, usually as of theclose of the last business day of May and November, coinciding with the May and November
Semi-Annual Index Reviews (SAIRs) of the MSCI Global Investable Market Indexes. The Barra
Equity Model data as of the end of April and October are used respectively. This approachaims to capture timely updates to the risk characteristics of the companies and coincide withthe rebalancing frequency of the relevant Parent Index. Similarly, the ESG data used for theSemi-annual Index Reviews will be taken as of the end of the month preceding the Index
Review i.e., April and October. For some securities, ESG data may not be published by MSCIESG Research by the end of the month preceding the Index Review. For such securities, MSCI
will use ESG data published after the end of month, when available, for the rebalancing of
MSCI Factor ESG Target Indexes. This approach aims to capture timely updates to ESG dataof the constituents and coincides with the rebalancing of the relevant MSCI Parent Indexes.
The pro forma MSCI Factor ESG Target Indexes are in general announced nine business days
before the effective date.

4.2

QUARTERLY INDEX REVIEWS
In addition to the SAIR, the ESG-based exclusions are applied on a quarterly basis at the timeof regular Quarterly Index Reviews (QIR) of the MSCI Global Investable Market Indexes,
usually as of the close of the last business day of February and August. At the quarterly index
reviews, the Indexes are not re-constituted, but existing constituents are deleted if they do
not satisfy the eligibility criteria as described in section 3.1 above. The ESG data used for the
QIR will be taken as of the end of the month preceding the Index Review i.e., January andJuly. For some securities, this data may not be published by MSCI ESG Research by the endof the month preceding the Index Review. For such securities, MSCI will use ESG data
published after the end of month, when available, for the rebalancing of MSCI Factor ESG
Target Indexes.

4.3

ONGOING EVENT RELATED CHANGESThe general treatment of corporate events in the MSCI Factor ESG Target Indexes aims tominimize turnover outside of Index Reviews. The methodology aims to appropriately
represent an investor’s participation in an event based on relevant deal terms and pre-event
weighting of the index constituents that are involved. Further, changes in index market© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

capitalization that occur as a result of corporate event implementation will be offset by acorresponding change in the Variable Weighting Factor (VWF) of the constituent.
Additionally, if the frequency of Index Reviews in the Parent Index is greater than thefrequency of Index Reviews in the MSCI Factor ESG Target Index, the changes made to the
Parent Index during intermediate Index Reviews will be neutralized in the MSCI Factor ESG
Target Index.
The following section briefly describes the treatment of common corporate events within
the MSCI Factor ESG Target Indexes.
No new securities will be added (except where noted below) to the Index between Index
Reviews. Parent Index deletions will be reflected simultaneously.
EVENT TYPE

EVENT DETAILSNew additions to the Parent Index

A new security added to the parent index(such as IPO and other early inclusions)will not be added to the index.

Spin-Offs

All securities created as a result of thespin-off of an existing Index constituent
will be added to the Index at the time of
event implementation. Reevaluation forcontinued inclusion in the Index will occur
at the subsequent Index Review.

Merger/Acquisition

For Mergers and Acquisitions, theacquirer’s post event weight will accountfor the proportionate amount of shares
involved in deal consideration, while cash
proceeds will be invested across theIndex.
If an existing Index constituent is acquiredby a non-Index constituent, the existing
constituent will be deleted from the Index
and the acquiring non-constituent will not
be added to the Index.

Changes in Security Characteristics

A security will continue to be an Index
constituent if there are changes in© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

characteristics (country, sector, size
segment, etc.) Reevaluation for continued
inclusion in the Index will occur at thesubsequent Index Review.
Further detail and illustration regarding specific treatment of corporate events relevant tothis Index can be found in the MSCI Corporate Events Methodology book under the sections
detailing the treatment of events in Capped Weighted and Non-Market Capitalization
Weighted indexes.
The MSCI Corporate Events methodology book is available at:https://www.msci.com/index-methodology© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

APPENDIX I: HANDLING INFEASIBLE OPTIMIZATIONS
During the Semi-Annual Index Review, in the event that there is no optimal solution thatsatisfies all the optimization constraints defined in Section 3.4, the following constraints arerelaxed, until an optimal solution is found:

Relax the maximum weight multiple in steps of 2 up to a maximum of 5 iterations
based upon the following formulawmi+1 = 2 + wmi 𝑓𝑜𝑟 𝑖 = 0 − 4
Where wmi = Maximum Active weight multiple
𝑤𝑚0 = 10 for Standard Indexes
For small cap indexes,

wm0 is 5 and it will be relaxed in the step of 1



Relax the turnover constraint in steps of 2%, up to a maximum of 30%



The maximum active weight multiple constraint and the maximum turnoverconstraint are alternately relaxed until a feasible solution is achieved. For example,
constraints relaxation is executed in the sequence as illustrated below:

Order ofMaximum Asset Weight Multiple

Turnover Limit

1

12 times the weight of the security in the Parent Index

20%

2

12 times the weight of the security in the Parent Index

22%

3

14 times the weight of the security in the Parent Index

22%

4

14 times the weight of the security in the Parent Index

24%

Relaxation

In the event that no optimal solution is found after the above constraints have been relaxedover all 5 iterations, the MSCI Factor ESG Target Index will not be rebalanced for that SemiAnnual Index Review.

© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

APPENDIX II: NEW RELEASE OF BARRA® EQUITY MODEL OR BARRA®
OPTIMIZER
The methodology presently uses MSCI Barra Global Equity Model for Long-Term Investors(“GEMLTL”) for the optimization. A new release of the relevant Barra Equity Model or Barra
Optimizer may replace the former version within a suitable timeframe.

© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

APPENDIX III: TARGET FACTOR DEFINITION SUMMARY
The style factors targeted in the MSCI Factor ESG Target Index are the six style factor
families and their combinations: Value, Quality, Momentum, Low Size, Yield and Low
Volatility. These factor families are described using individual factor scores from the current
release of the MSCI Barra Equity Model. The choice of factors used within each factor family
is governed by the current model used for the optimization, which may change with a newrelease of the Barra Equity Model (as specified in Appendix II). The model data will be usedfrom previous end-of-month, prior to the rebalancing date. Following are the definitions offactor families currently used in the Index. For more detailed information on individual
factors in GEMLTL, please refer to https://www.msci.com/portfolio-management
Value:The value score for each security is calculated by combining the security-level exposures to
two factors, Book-to-Price and Earnings Yield, from the GEMLTL model. A sector-relativescore is derived from the combined score by standardizing the latter within each sector andwinsorizing at +/- 3
Valuei = (0.33) ∗ BtoPi + (0.67) ∗ EarningsYieldi

Quality:
The quality score for each security is calculated by combining in equal proportion the
security-level exposures to five factors - Profitability, Investment Quality, Earnings Quality,
Leverage and Earnings Variability - from GEMLTL model. A sector-relative score is derived
from the combined score by standardizing the latter within each sector and winsorizing at+/- 3
Qualityi = (0.2) ∗ Profitabilityi + (0.2) ∗ Investment Qualityi + (0.2) ∗ Earnings Qualityi+ (−1) ∗ (0.2) ∗ Earnings Variabilityi + (−1) ∗ (0.2) ∗ Leveragei
Low Volatility:
The low volatility score for each security is calculated by combining in equal proportion the
security-level exposures to two factors - Beta and Residual Volatility - from GEMLTL model.
Low Volatilityi = (−1) ∗ (0.5) ∗ Betai + (−1) ∗ (0.5) ∗ Residual Volatilityi
Momentum:© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

The momentum score for each security is same as the Momentum factor score in the
GEMLTL Barra Equity Model
Low Size:
The low size score for each security is represented by the Size factor score in the GEMLTLBarra Equity Model with sign reversed.
Low Sizei = (−1) ∗ Sizei
Yield:The yield factor score for each security is same as the Dividend Yield factor score in the
GEMLTL Barra Equity Model with sign reversed.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

APPENDIX IV: CONTROVERSY SCORE AND CONTROVERSIALWEAPONS EXCLUSION CRITERIAESG Controversy Score (“Red Flags”)

Securities of companies having faced very severe controversies pertaining to ESG issues are
not eligible for inclusion in the Index. This is implemented by excluding constituents of
Parent Index with MSCI ESG Controversy Score = 0 (“Red Flag” companies). For more details
on MSCI ESG Controversies Score, please refer to https://www.msci.com/esg-integration

Controversial Weapons Involvement

For details, please refer to MSCI Global ex Controversial Weapons Indexes Methodology at
https://www.msci.com/index-methodology .

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017

The following sections have been modified since September 2017:Clarified the mean-variance optimization problem solved in the index construction in
the Introduction (Section 1) and section 3.



Added a description of the values used for the common factor risk aversion and thespecific aversion parameters used in the optimization in Section 3.4.

Updated Appendix III to explain the dependence of the precise factor definitions usedwithin each target factor on the Barra model currently used for optimization.

© 2017 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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MSCI FACTOR ESG TARGET SERIES INDEXES METHODOLOGY | NOVEMBER 2017CONTACT US
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