Going Green for Gold

MSCI, one of the world's largest index providers, has recently released a research paper, Foundations of ESG investing,¹ which evaluates how ESG characteristics have led to financially significant corporate performance.

The paper presents compelling reasons to include highly rated ESG companies in your portfolio.

MSCI assessed the influence of ESG characteristics on cash flow and risk levels. It also quantified the impact of ESG momentum, that is, an improvement in ESG ratings.

In terms of cash-flow analysis, MSCI found data supporting the assertion that high ESG-rated companies were more profitable and paid higher dividends. The performance contribution of dividends to portfolio returns was increasingly important as investment time horizons lengthened.

_{Source: MSCI}

Second, in terms of risk, MSCI found that the stock prices of companies with a high ESG rating typically have shown lower systematic and tail risk, as outlined below:

_{Source: MSCI}

Finally, in terms of ESG momentum, MSCI found that improvement in a company's ESG characteristics led to increasing valuations over time. The authors found statistically significant predictive power of ESG momentum for stock returns. MSCI concludes that ESG momentum can be a useful financial indicator in its own right and may be used in addition to the actual ESG rating in index or portfolio construction methodologies.

Other studies point to ESG enhancement

In a separate study, JP Morgan has concluded that "ESG can enhance your portfolio by reducing volatility, increasing Sharpe ratios and limiting drawdowns." In particular, "not having ESG factors in your portfolio significantly increases volatility, lowers potential Sharpe ratios and leads to a higher probability of suffering larger drawdowns during times of market stress."²

Other research supports these conclusions. Analysis from Credit Suisse³ finds that integrating ESG factors can enhance portfolio performance through both lower exposure to negative risks related to environmental, social and corporate governance issues and higher exposure to related opportunities, which can lead to material cost advantages, improved efficiencies and new revenue sources.

Credit Suisse also found that ESG ratings are a possible lead indicator of management quality in that companies which are better managers of ESG factors may also be better managers of shareholder capital.

An example of a highly ESG rated company which has easily outperformed its peers is Allianz a European financial services conglomerate with its core business being insurance and asset management. The company has a AAA ESG rating from MSCI. Allianz has outperformed the broader global financials market as represented by the MSCI World Financials Index as the below chart shows.

_{Source: MSCI, Morningstar Direct VanEck. Results are calculated monthly and assume immediate reinvestment of all dividends. Data converted to Australian dollars. You cannot invest in an index. Past performance is not a reliable indicator of future performance.}

Until recently, it has been particularly hard for passive managers, who track indices, to include effective qualitative ESG research into their products.

Until now.

VanEck has partnered with MSCI to create a state-of-the-art index that combines all of MSCI's ESG and SRI data and expertise. The index, MSCI World ex Australia ex Fossil Fuel Select SRI and Low Carbon Capped Index (ESGI Index), incorporates both values-based and impact investing.

The index is backed by research from MSCI and its team of over 170 analysts worldwide who assess all of the stocks in its global universe on a 'AAA' to 'CCC' scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to peers.  

The robustness of MSCI's ESG research was reinforced during the recent Facebook/Cambridge Analytica scandal. ESGI Index avoided Facebook as that company ranks in the bottom quartile of MSCI's Privacy and Data Security Key Issue analysis compared to industry peers with a score of 2.7/10. Facebook was not in the ESGI Index therefore avoiding Facebook's price crash.

Companies in the ESGI Index are selected from the MSCI World ex Australia Index through a four-step screening process based on:

1. Fossil fuels exclusion
   Companies that have proved and probable coal reserves and/or oil and natural gas reserves used for energy purposes are excluded.
   
   
2. Socially Responsible Investing (SRI) exclusion
   Companies whose businesses are involved in or exposed to the following activities are excluded:
   • alcohol
   • gambling
   • tobacco
   • military weapons
   • civilian firearms
   • nuclear power
   • adult entertainment
   • genetically modified organisms (GMOs).
     
     
3. High rating ESG inclusion
   MSCI ESG Research data is then used to include only the leading ESG performers in each GICS sector, or the top 15% in each sector of the MSCI World ex Australia Index.
   
   
4. High carbon emitters excluded
   Remaining companies from step 3 are then ranked by carbon emission intensity and the top 20% by number are excluded. The cumulative weight of securities excluded from any GICS sector is capped at 30% of the weight of the sectors from step 3 so that sector weights are not excessively disrup
   
   Securities are also excluded until the cumulative potential carbon emissions of the excluded companies reaches 50% of the sum of the potential carbon emissions of the constituents

VanEck Vectors MSCI International Sustainable Equity ETF (ASX: ESGI) tracks the ESGI Index and it started trading on ASX in March.

Now investors committed to sustainable investing and who want to align their investments to their ethics and values, and which investment performance is supported by research, can access a portfolio of ~200 international ESG leaders in a single trade on ASX.

_{IMPORTANT NOTICE:
This information is issued by VanEck Investments Limited ABN 22 146 596 116 AFSL 416755 ('VanEck') as responsible entity and issuer of the VanEck Vectors MSCI International Sustainable Equity ETF ('Fund'). This is general information only and not financial advice. It does not take into account any person's individual objectives, financial situation or needs. Before making an investment decision in relation to the Fund, you should read the PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. The PDS is available at www.vaneck.com.au or by calling 1300 68 38 37. The Fund is subject to investment risk, including possible loss of capital invested. Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance, or any particular rate of return from the Fund.   The Fund is indexed to a MSCI index. The Fund is not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to the Fund or the MSCI Index. The PDS contains a more detailed description of the limited relationship MSCI has with VanEck and the Fund.}

_{ESGI is indexed to a MSCI index. ESGI is not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to ESGI or the MSCI Index. The PDS contains a more detailed description of the limited relationship MSCI has with VanEck and ESGI.}

_{¹ MSCI, 2017, 'Foundation of ESG Investing. Part 1: How ESG Affects Equity Valuation, Risk and Performance'}

_{² JP Morgan 2016, 'A Quantitative Perspective of how ESG can Enhance your Portfolio'}

_{³ Credit Suisse 2015, 'Finding Alpha in ESG'.}