— GENERAL —PRODUCT INSIGHTMSCI ESG ENHANCED
FOCUS INDEXESA Customized Index Combining ESG with Low Carbon Investing
Guido Giese
March 2019

MARCH 2019

— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019

INTRODUCING THE MSCI ESG ENHANCED FOCUS INDEXESThe size of the ESG investment markets has grown substantially in recent years, with thenumber of UN PRI signatories reaching 1,900 and with 81.7 trillion USD in invested ESG
assets as of end-2018 1. Historically, many ESG investors applied exclusionary screens totheir portfolios to align their investments with their beliefs, e.g., by divesting fromtobacco, alcohol or weapons.
However, in recent years ESG investing trends have been driven by more investors
seeking not only social benefits but also managing financial risks and opportunities. In
fact, a recent survey indicated that most asset owners surveyed see the management offinancial risks as the key benefit of ESG.2
In addition, after the COP 21 conference in 2015, many investors3 came to realize thatclimate change is not only an environmental topic but also a financial risk that will very
likely have a material impact on many companies’ profitability during the global
transition toward a low carbon economy. An estimated 25 trillion USD invested incarbon-related infrastructure is thought to be at risk4 from this transition. For instance,the 22 billion USD write-down that General Electric5 announced for its turbine businessin 2018 indicated how carbon transition risk spreads across different industries and may
affect the entire economic system, as well as the financial performance of investors.
In addition, various regulators have issued recommendations regarding the use of ESG
information in asset management. For instance, the U.K. Pensions Regulator asks
trustees of U.K. pension funds to consider ESG factors in their investment decisions
when they are deemed financially material6.
For many portfolio managers and financial product providers, the key challenge is toaddress investors’ motivation for exclusionary screens as well as financially relevant ESG
risks in their portfolio construction methodology. This can be particularly challenging
when investors would like to achieve their ESG-related objectives under strict financial
1 United Nations Principles for Responsible Investing.

https://www.unpri.org/

2

Eccles, R., M. Kastrapeli and S. Potter. (2017). “How to Integrate ESG into Investment-Decision Making: Results of a
Global Survey of Institutional Investors.” Journal of Applied Corporate Finance, Vol. 29, No.4, pp. 125-133.
3 See https://theinvestoragenda.org/areas-of-impact/policy-advocacy/
4 Carbon Tracker 2020 Vision: Why you should See Peak Fossil Fuels Coming. www.carbontracker.org
5 See 2018 Annual Report of GE.
6 See “A Guide to Investment Governance” by the Pensions Regulator, November 2018.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019

constraints, such as keeping the level of diversification and tracking error close tobenchmark and achieving a similar risk-return profile.
The customized MSCI ESG Enhanced Focus Index series is designed to help clients
address this challenge: Starting from a standard market cap parent index, it first applies
the most commonly used exclusions screens in the asset management market and thenincreases the weight of companies with good ESG and carbon profiles, while aiming tomaintain a risk and diversification profile that is close to the parent index.
The index methodology includes an exclusionary step and an optimization step:
1. Exclusions: The MSCI ESG Enhanced Focus Index applies the most common
exclusions to the underlying market cap benchmark across the E, S and G
categories as shown in Exhibit 1. Exclusions can be driven by different
motivations, e.g., investors’ beliefs, regulation or risk considerations.
Divestment from thermal coal and oil sands is a global trend that is followed byseveral large investors, including some large global insurers. Divesting from
nuclear weapons and firearms has been a focus of socially conscious investors
from the very beginning of ESG investing. This step is designed to exclude
companies commonly deemed controversial from the MSCI ESG Enhanced Focus
Indexes.
Exhibit 1: Exclusionary Screens for MSCI ESG Enhanced Focus Index

Source: MSCI

2. ESG and carbon optimization: To achieve the optimal ESG integration versus
tracking error trade-off, the main step in the index construction methodology
maximizes the index-weighted ESG score under a tracking error constraint of© 2019 MSCI Inc. All rights reserved. Please refer to the disclaimer at the end of this document.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019

0.5% p.a. and a constraint of at least 30% reduction in index-weighted carbon
intensity.7

MSCI ESG ENHANCED FOCUS INDEX PROFILE
In the period of analysis, Nov. 30, 2012 to Dec. 31, 2018,8 the MSCI ACWI ESG Enhanced
Focus Index covered over 90% of the market by free-float market capitalization (Exhibit2) and had a realized tracking error of 0.6%. Performance and risk figures (volatility,draw-down) as well as index liquidity (annualized traded value ratio – ATVR) also
showed performance close to the parent index.9 At the same time, we saw a clear
increase in index turnover to above 20%, due to the optimization process used. Thislevel of turnover was comparable to the turnover seen in quality, minimum volatility
and dividend yield factor indexes, which all experienced turnover rates above 20%,
while the momentum index exhibited turnover above 90% during the study period from
November 1975 to March 2014.10
Due to the optimization process above, the MSCI ACWI ESG Enhanced Focus Indexachieved a 21% increase in the index-weighted MSCI ESG score compared to its
benchmark (Exhibit 2). To put this into perspective, this level of increase wascomparable to the ESG improvement obtained by a 50% best-in-class selection of ESGrated companies as used in the MSCI ESG Leaders index. The improvement in the ESG
profile was also reflected by exposure to ESG Leaders (companies rated AAA and AA)
more than doubling while exposure to ESG Laggards (companies rated BBB and C)
reduced compared to the parent index.
At the same time, we observed a significant reduction in terms of both the actual
carbon emissions reflected by the index, due to the carbon-intensity reduction
constraint in the optimization process, and in potential future emissions due to the
exclusions screen on thermal coal and oil sands.

7

Carbon intensity is defined as a company’s annual carbon emissions in tons divided by its annual sales in USD.

8 The index was backtested starting from November 30, 2012.
9This report may contain analysis of historical data, which may include hypothetical, backtested or simulated
performance results. There are frequently material differences between backtested or simulated performance results
and actual results subsequently achieved by any investment strategy.
10 Alighanbari, M., R. A. Subramanian and P. Kulkarni. (2014). “Factor Indexes in Perspective. Insights from 40 Years ofData. Part 1: The Study.” MSCI Research Insight.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019

Exhibit 2: Key Index Metrics Comparison
MSCI ACWI Index
Total Return (%)
8.0
Total Risk (%)
10.7
Sharpe Ratio
0.69
Tracking Error (%)
0
Information Ratio
Max Drawdown (%)
18.9
No of Stocks*
2495
Parent Index Coverage* (%)
100
Large* (%)
82.7
Mid* (%)
17.3
11
Turnover (%)
2.7
Weighted Average ATVR (%)
100.7
ESG score
5.7
ESG Leaders (AAA-AA) (%)
23.2
ESG Laggards (B-CCC) (%)
11.1
Carbon Intensity (t CO2e/$M Sales)
232
Potential Carbon Emissions (t CO2e/$M
3574
Invested)
Period from Nov. 30, 2012 to Dec. 31, 2018. (*monthly averages)

MSCI ACWI ESG
Enhanced Focus Index
8.2
10.8
0.7
0.6
0.34
18.8
2329
92.5
82.8
17.2
21.8
99.9
6.9
46.8
5.1
149 (-35.8%)
1991 (-44.3%)

In brief, the backtested performance of the MSCI ACWI ESG Enhanced Focus Index was
similar to the underlying MSCI ACWI Index. At the same time, the index tilted toward
companies with high ESG Ratings and strong carbon efficiency profiles.

POTENTIAL APPLICATIONS
Indexes are often used as benchmarks at both a strategic and an implementation level.
Investors may use policy benchmarks in their strategic asset allocation to define eligible
markets and the universe of eligible securities for their portfolios. At the same time,they may use them to define active or passive allocations when implementing theirasset allocation strategies.
We have observed an increasing number of investors incorporating ESG considerations
into their investment process: For instance, ESG Ratings are sometimes used by clients
11 Annualized one-way index turnover over index reviews.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019to assess corporate headline risks that can threaten the reputation of the asset
manager. In addition, in recent years many investors have identified carbon transition
risks, as pressure both from regulators and from technological progress in green energy
sources can potentially pose a risk to companies that are heavily reliant on fossil fuels.
For the purpose of consistency and transparency, investors who have decided toaddress these ESG-related issues across their portfolios may want such considerations
to be reflected in their benchmarks, since benchmarks are typically used across all ofinvestors’ portfolios, whether they are active, passive or factor-based.
As illustrated in the previous exhibit, as well as that below, active size and sector
weights for the MSCI ACWI ESG Enhanced Focus Index were fairly small. However, theuse of MSCI Industry-adjusted ESG scores, together with a strict tracking-error
constraint in index construction, kept sector and size deviations at low levels during the
backtested period – despite the fact that certain exclusionary screens have been applied
to the base universe (Exhibit 1).
Exhibit 3: Active Sector Weights in MSCI ACWI ESG Enhanced Focus Index
SectorEnergyMaterials
Industrials
Consumer Discretionary
Consumer Staples
Health Care
Financials
Information Technology
Communication Services
Utilities
Real Estate
Stdev

Active weight %

-1.5
-0.3
2.1
-0.8
-0.6
-1.1
0.4
1.2
0.3
0.0
0.3
1.0

Simulated data as of Dec. 31, 2018. Not indicative of future performance.

In addition, active exposures and returns due to country and equity style factor shifts
were small during the study period (Exhibit 4). It is important to note that these active
factor exposures and their performance impact are simulated, unintended exposuresand may vary over time.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019

Exhibit 4: Active Country (left) and Style Exposures (right) in MSCI ACWI ESG Enhanced
Focus Index

Period from Nov. 30, 2012 to Dec. 31, 2018.

CONCLUSION
Addressing corporate ESG risks and the risks of the global transition to low carbon is
becoming increasingly important for many investors. At the same time, an increasing
number of national regulators are requiring institutional investors to consider ESG andcarbon risks that may be financially relevant to their investment processes.
The MSCI ESG Enhanced Focus indexes are designed to help institutional investors
measure ESG risks and carbon risks in their strategic asset management framework,
while maintaining a low tracking error relative to the underlying broad-based index. In
addition, these indexes exclude business activities that are commonly seen as
controversial, such as tobacco production and weapons manufacturing.

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— GENERAL —MSCI ESG ENHANCED FOCUS INDEXES | MARCH 2019NOTICE ANDDISCLAIMER

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