The MSCI SRI indices target inclusion of approximately 25% of all index constituents, using a so-called best-in-class approach. This is to make sure the SRI indices aren’t skewed too much towards certain sectors. Companies are evaluated on their ESG credentials, and are assigned an ESG score. The top-25% in each sector are then selected for inclusion.
There also is an ESG index that applies a lighter filter. The ESG indices target 50% coverage of each sector, focusing on exclusions and headline ESG risks,” says Stuart Doole, head of research at MSCI. Though the methodology is different, the two indices actually show rather similar performance over the longer term.
SRI performance drag
While ESG-screened ETFs that track emerging market indices have a relatively high tracking error, this isn’t that much an issue for other regions. The outperformance these trackers generate is not as dramatic either. Moreover, applying an ESG-filter can even be a drag on performance.
The reason that the MSCI World SRI index has only recently started to outperform its plain vanilla counterpart, is the fact that the SRI-filter has produced negative returns for the world’s largest equity market: the US.
The exclusion of tobacco companies caused the ESG and SRI indices to not perform as well and, as Andrew Walsh, head of ETF sales at UBS Asset Management, put it: “The all-star team of Facebook, Apple, Netflix, Amazon and Alphabet (Google) [the famous FANG stocks] haven’t made it to the USA index,” says.
For Google, this is because it scores low on governance: “The shareholder structure [with Google founders Larry Page and Sergey Brin retaining control over the company], the limited protection of privacy and the legal cases with the EU that Google is involved in all play their part in that,” explains MSCI’s Doole.
