Optimizing Environmental, Social and Governance Factors in Portfolio Construction: Analysis of Three ESG-Tilted Strategies

Abstract

Institutional investors wanting to integrate Environmental, Social and Governance (ESG) factors in their investment strategies need the right tools to measure portfolio risk characteristics and performance. MSCI’s BarraOne and Barra Portfolio Manager can provide this utility with Intangible Value Assessment (IVA) ratings from MSCI ESG Research. In this study, we examine the use of IVA ratings with the Barra Global Equity Model (GEM3) to build optimized portfolios with improved ESG ratings, while keeping risk, performance, country, industry, and style characteristics similar to conventional benchmarks, such as the MSCI World Index. The currently available dataset of IVA scores allowed us to compare three strategies during the period between February 2008 and December 2012, using current IVA ratings methodology. Of the three strategies, we found the best active returns during this period were achieved by overweighting firms whose IVA ratings improved over the recent time period, showing ESG momentum. Underweighting assets with low ESG ratings also raised portfolio performance during this period. The highest ESG rated assets had more uneven performance; they generally did better in periods of limited risk appetite during this volatile market cycle.

Keywords: ESG ratings, ESG factors, ESG tilt, ESG momentum, portfolio risk, risk optimization techniques, social values, time series analysis, Intangible Value Assessment, Barra, MSCI World Index

JEL Classification: A13, C12, C22, C61