MSCI: How 30 Years of ESG Indexing Informs Portfolio Construction
Whatever type of new normal emerges from the coronavirus pandemic, the upheaval it has triggered has investors examining anew the ability of companies to withstand unexpected events and exogenous shocks.
From the interrelatedness of supply chains, to the importance of health and safety and the interdependence of companies and communities, the pandemic partially underscores the significance of environmental, social and governance (ESG) factors in identifying and assessing such risks.
It also highlights the extent to which investors have internalized ESG strategies. In a recent GAO survey, 12 of the 14 institutional investors interviewed look to ESG factors to better understand the risks that companies face over time. Assets in exchange-traded funds and the number of such funds themselves have surged in recent years.
As it happens, index-based investing and ESG investing met 30 years ago this year, when Peter Kinder, Steve Lydenberg and Amy Domini, who together ran a research firm in Boston, assembled a set of socially responsible stocks they called the KLD 400 Social Index.
Visit MSCI’s interactive timeline, which traces the evolution of ESG indexes that began with the launch of the world’s first socially responsible index in 1990.
By then socially responsible and ethical investing had been a well-known practice of faith-based organizations1. In the 1980s, it crossed a watershed in the divestment campaign against apartheid South Africa. But by collecting companies based on their commitment to social and environmental issues (at a time when few companies disclosed such information voluntarily), the KLD 400 Social Index offered an investment universe that enabled investors to benchmark the performance of ESG strategies.
The index, which MSCI acquired as part of KLD Research & Analytics in 2010, has a decades-long track record and is still running in real time. It supports at least three insights that can inform how investors construct portfolios.
The first is that responsible investing does not necessarily equate to underperformance and that conventional investment factors are general determinative of difference in performance between ESG investment and the S&P 500.2 Though the methodology used to construct the index has evolved over time, the MSCI KLD 400 Social Index has, since inception, generated a total return of 10.43% compared to 10.07% for the MSCI USA Index, a 36 basis points (bps) difference (as of May 31). This spread has also been maintained during the last five years, as the MSCI KLD 400 Social Index outperformed the MSCI USA Index 10.37% versus 9.84%, a 53 bps difference.
30 Years of Performance
As the history suggests, companies that showed strengths in environmental and social responsibility (the term ESG was not coined until 2005) tended to be more profitable, with better returns on investment, than companies excluded from the index. On average, the index increased exposure to the best-performing companies and reduced exposure to the worst performers.
Second, while many ESG indexes today maintain similar sector exposures relative to the broad market, the 30 years of history for the MSCI KLD 400 index reminds us that the industries and business models of tomorrow may lie beyond our contemplation today. Fourteen of the top 25 constituents of the MSCI KLD 400 Social Index in May 2020 were not constituents at inception; they either had not yet been listed, were the product of M&A or spin-off action, or existed but did not qualify for inclusion.3
As of May 2020, Microsoft, Facebook and Alphabet anchored the index. Two of those companies did not exist in 1990. The third, Microsoft, was not a constituent and was still a relatively nascent company focused on extending the dominance of MS-DOS.
As it happens, the growth of technology in transforming our everyday life has also enabled more investors to adopt ESG in their investment process. Thirty years ago, companies submitted securities filings on paper and frameworks such as the Global Reporting Initiative had yet to be established. Now advances in computing enable us to analyze and extract meaning from a myriad of information sources that shed light on the risk companies confront, the innovations they pursue, and the practices that govern them.
Finally, if we’ve learned anything in 30 years, it’s that ESG has less to do with disclosures that companies tuck into boilerplate than it does with the capacity of companies to address the risks and opportunities denoted by the three pillars of ESG.
That’s what ESG attempts to quantify. For example, we know from the newest research that governance has been more relevant than environmental and social indicators in terms of their impact on profitability, idiosyncratic risk and systematic risk over a relatively short period of time such as one year. By contrast, environmental and social indicators have tended to grow in relevance over multiple years.
ESG shines a light on some of the characteristics of companies that are most difficult to quantify and often times on risks that have yet to materialize. That helps explains why investors increasingly bring an ESG lens to their investments. Whether they are building strategies to track demographic trends, robotics or electric vehicles, creating ESG-focused investment products, or looking to benchmark performance of complex portfolios, our interactions with clients and market participants point to an increasing demand for ESG optimization incorporated into indexes by design.
As the pandemic reminds us, the risk from events that stretch the capacity of companies is all too real and often those risks show up in the bottom line. We turn to ESG investing because we know that building a sustainable business starts with a recognition that we’re all in this together.
Article by Linda-Eling Lee, Managing Director and Global Head of ESG Research, MSCI
As Global Head of Research for MSCI’s ESG Research group, Linda-Eling Lee oversees all ESG-related content and methodology. MSCI ESG Research is the largest provider of ESG Rating and analytics to global institutional investors. Linda leads one of the largest teams of research analysts in the world who are dedicated to identifying risks and opportunities arising from material ESG issues. She and her team have been widely recognised as the best SRI/ESG researchers by market surveys and awards.
Linda joined MSCI in 2010 following the acquisition of RiskMetrics, where she led ESG ratings research and was head of consumer sector analysis. Linda joined RiskMetrics Group in 2009 through the acquisition of Innovest. Prior to joining Innovest, Linda was the Research Director at the Center for Research on Corporate Performance, developing academic research at Harvard Business School into management tools to drive long-term corporate performance.
Previously, she was a strategy consultant with Monitor Group in Europe and in Asia, where she worked with Fortune 500 clients in industries ranging from beverages to telecommunications. Linda received her AB from Harvard, MSt from Oxford, and PhD in Organizational Behavior from Harvard University.
Linda has published research both in management journals such as the Harvard Business Review and MIT’s Sloan Management Review, as well as in top academic peer-reviewed journals such as Management Science and Journal of Organizational Behavior. She is frequent media commentator on ESG topics and sustainable investing in outlets including the Financial Times, Wall Street Journal, Forbes and the New York Times.
Footnotes:
[1] https://www.investopedia.com/news/history-impact-investing
[2] The Long-Term Performance of a Social Investment Universe (Kurtz; DiBartolomeo) compares U.S. social investing to the S&P 500 index.
[3] Source: MSCI. Data as of May 2020. Informational purposes only. Past performance is not indicative of future results. MSCI ESG Indexes utilize data from but are not provided by MSCI ESG Research LLC. MSCI ESG Indexes are products of MSCI Inc. and are administered by MSCI Limited (UK).