In this Q&A, Thomas Kuh and Paul Schutzman, Executive Directors at MSCI, discuss the significant ESG trends and developments that we should be aware of in 2017, some of the ESG concerns, demands and questions they hear most frequently from asset owners in the US, and what first steps institutions that are grappling with how to approach ESG can take.
Thomas Kuh Paul Schutzman
Executive Director, MSCI Executive Director, MSCI
1. Can you please explain your roles at MSCI for our IEN readers?
Paul: I lead our US Index Client Coverage team focusing on Asset Owners. We work with public and corporate defined benefit and defined contribution plans, endowments and foundations to help them understand and leverage MSCI Index offerings, methodologies, and use cases. The world of indexes has become more complex as we have incorporated new elements, such as risk factors and ESG data, into index construction. While benchmarks have long been essential to institutional investors’ approach to risk management and performance evaluation, the growth of passive strategies and the proliferation of index types have increased the need to keep asset owners well informed.
Tom: I work on ESG Indexes as a member of the global index product team at MSCI. This role involves supporting our Client Coverage team to help them license the indexes to clients for performance benchmarking and creation of passive products, and providing feedback on market trends to our product development team as they develop new indexes.
2. What are the significant ESG trends and developments that we should be aware of in 2017?
We are seeing strong momentum behind the ESG investing wave we have been experiencing over the past decade or so. The understanding of ESG and the implementation options are continuing to evolve. At MSCI we define the three main approaches to ESG investing as follows: 1) ESG integration; 2) values-based investing or exclusionary screening; and 3) impact investing.
Amongst our endowment and foundation clients specifically, we see increasing adoption of values-based approaches that prohibit investments in specific business-related activities that run contrary to an organization’s mission. We also see smaller sized but increasing allocations to impact investments that target market-level or concessionary returns, while supporting specific environmental and social goals. The most widespread growth has been in the area of ESG integration, in which ESG considerations and analysis are incorporated into portfolio construction with the goal of maximizing long-term risk/return objectives.
Part of what has enabled the depth of integration we are seeing is the degree to which the state of ESG research has matured. The quality and sophistication of ESG data is more advanced than ever. MSCI ESG Research’s 2017 ESG Trends to Watch paper highlights the historical relationship between ESG and risk-adjusted returns, suggesting that the conversation is shifting from “how” to use ESG to “where” to use ESG, given the diverse portfolio applications and nuances in data now available. Further, academic literature has suggested a link between material ESG factors and performance, such as this Harvard Business School study published in March 2015.
3. What are some of the ESG concerns, demands and questions you are hearing most frequently from asset owners in the US?
There are a range of questions around ESG coming from asset owners, reflecting the varying stages of ESG integration. There are still many questions that are definitional: What is ESG investing? How can we articulate and incorporate ESG beliefs into our investment policies? With the term integration, for example, many asset owners aren’t sure where to get started or how to understand if their external managers are effectively incorporating ESG factors into their portfolios.
We still have many asset owners with concerns about the potential impact on performance and their roles as fiduciaries and stewards of capital tasked with maximizing long-term returns. Often, a growing understanding of the determination of materiality, academic and practitioner research, as well as institutional support such as the DOL's Interpretive Bulletin in October 2015, is a start towards alleviating these concerns.
We now have a growing number of clients asking what their major portfolio exposures are to ESG risks. For example, are they able to measure and account for these exposures and do they have methods to manage around them? If we just think about public equity portfolios, how should ESG be combined with active or passive mandates? Should it be a separate allocation segment in the portfolio or should a standard approach be applied to all investments? These are all legitimate questions that don’t have a “one size fits all” answer but that require further exploration.
4. For institutions grappling with how to approach ESG, what do you commonly see as a first step taken and can you recommend any resources?
A common first step for institutions is to develop an ESG policy or to add a segment reflecting their philosophy on ESG within their investment policy. This exercise often leads to questions about how to align the investment policy of an organization with its mission. From this exercise we often find that asset owners would like a more holistic understanding of their existing portfolio, including a baseline view of their ESG profile versus appropriate benchmarks and their peers.
Case Study: Carbon Portfolio Footprinting
While more holistic ESG portfolio analytics are available, in this case study we focus on carbon as many investors today are looking to understand their portfolio exposure to climate change.
For the sample equity portfolio shown below, we analyze the securities in that portfolio in terms of the carbon emissions, fossil fuel reserves, and other carbon-related characteristics of the entities that issue those securities. We then compare this data to the performance of a portfolio replicating a market benchmarking (MSCI World Index) and a portfolio replicating a relevant ESG benchmark (MSCI World Low Carbon Target Index).
MSCI ESG Research defines portfolio carbon footprint as the carbon emissions of a portfolio per $ million invested. For more information on MSCI ESG Research’s carbon tools visit https://www.msci.com/carbon-solutions or inquire at [email protected].
5. How does MSCI and MSCI’s role relate to other key actors in the ESG ecosystem?
MSCI, through MSCI ESG Research, is the largest ESG research provider by coverage and number of clients in the marketplace, serving asset owners, asset managers and consultants. Through MSCI ESG Ratings and research, risk analytics and indexes, MSCI provides a broad range of tools that are used to support all three approaches to ESG investing- integration, impact and values – and that are resources for trustees, investment committees, consultants and asset managers.
There is now an ecosystem that serves all sizes and types of asset owners from the largest public pension funds to modest sized endowments and foundations. MSCI provides ESG indexes that are used as benchmarks for active managers or as the basis for passive investment options. MSCI ESG Research also provides ESG research and ratings that are used by many active asset managers.
Thank you both for your time and thoughtful answers to these questions!