Green Smart Beta Will Be The Next Innovation

Investors won’t have failed to notice the recent spate of environmental, social and governance (ESG) funds of late. This year alone there have been four ESG exchange traded funds (ETFs) in Europe, including one from UBS that focuses on “sustainable” corporate bonds. Could a green smart beta ETF be next?

MSCI is the major indexer in the ESG space – it is number one in terms of ETF assets linked to ESG equity indexes, and year-to-date inflows are around $194 million in Europe. MSCI has claimed almost half - 48 percent - of that.

ETF.com speaks to Deborah Yang, managing director, head of the MSCI index business in EMEA and South Asia, and Thomas Kuh, global head of ESG research, about how being green can extend to other asset classes like bonds and smart beta, and why the new Pope is driving investors back to its Catholic indexes.

ETF.com: Do you have any view as to why ESG has been the focus of various launches recently in Europe?

Deborah Yang: We’re seeing momentum on topics like the environment and low carbon as regulation and European countries are coming together on this theme. Thought leaders like pension funds and high profile events are pushing the institutionalisation of ESG indexes forward.

An interesting transformation is taking place in the institutional investor base in Europe in particular, whereby they are starting to use ESG indexes as a policy benchmark or as an overlay for a mandate. Last year, for example, the Swedish pension fund AMF adopted a policy benchmark using MSCI ESG and we are having many other discussions as well as adoption of these indexes for policy benchmarks or mandates. As a result we believe there’s increasing demand for MSCI ESG research, indexes and ultimately the licensing and creation of ESG ETFs.

ETF.com: Many ESG indexes are choosing a selection of stocks from a larger, parent index – essentially they are limited to selecting the best of a bad bunch?

Thomas Kuh: It’s fair to say that from a sustainability perspective no company is perfect. Our view is investors are looking for companies that are addressing the risks and opportunities that are associated with ESG stocks in the context of the industries in which they operate. We use a best-in-class methodology for our sustainability indexes which tries to identify companies that have ESG ratings that are superior to their peers and are not engaged in high profile controversies.

We have a team of more than 220 people in ESG research and their focus is developing the ratings and data that allow us to make distinctions and understand within each industry which companies have better sustainability records.

ETF.com: What’s your view on positive versus negative screening of companies to be included or excluded from an index?

Kuh: We found there is an appetite for a combination of both the best-in-class approach – a way of identifying those companies that stand out compared to their peers – as well as avoiding companies and industries like the tobacco industry or GMOs [genetically modified organisms] etc. We use both approaches. It would depend what the interest of investors are.

ETF.com: Can you tell me more about the sustainable bond index that has been adopted by a UBS ETF in September?

Kuh: These are very research-driven benchmarks. One of the underlying objectives is to provide tools for investment for those who are interested in sustainability. While for many years that research was very much focused on the equity market, several years ago we began to extend our analysis. We partnered with Barclays to take advantage of their expertise in fixed income indexes, combining that with MSCI’s expertise in ESG research. We can broaden our coverage to different types of fixed income securities and we developed a set of transparent rules to construct these indices. They are based on the Barclays Global Aggregate index with certain criteria applied.

ETF.com: Are these indexes more concentrated than the plain vanilla?

Kuh: The equity indexes are a subset of parent indexes and as a result they will be somewhat more concentrated. In addition to applying a similar best-in-class approach in the fixed income space, we also have ESG-weighted indexes, so rather than taking a subset of the parent index, we tilt to higher rated companies rather than lower weighted companies.

ETF.com: Have you seen a decline in religious ETFs?

Kuh: No. In fact I would say we’ve seen growing interest in both Islamic and Catholic indexes. I think part of what’s driving the interest on the Catholic side is the Pope – the current Pope has been very visible and outspoken on issues related to the church and its role in society on things like climate change and poverty alleviation. I think that’s reinvigorated interest in investing which combines the teachings of the church with sustainability.

ETF.com: How will ESG indexes become more innovative?

Kuh: There is a lot of innovation going on right now. Just a year ago MSCI launched a family of low carbon indexes which are designed to reduce the portfolio exposure to carbon emissions and carbon reserves. These equity indexes track with about 150 basispoints relative to the market on a global basis. We’ve also launched ex-fossil fuel indexes.

One of the most interesting developments recently is that investors, say a large pension fund, have an allocation to our factor indexes but also want a low carbon methodology on top. Because we have the ability to do both, we are uniquely positioned to applying that solution.