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BENCHMARKING ESG
A brief analysis of different sustainability indexes
Panorama 22 Jun 2023 7 min read
Authors
Michele Gambera Alexander Eisele Ryan F. Primmer
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When shopping for sugar, we are spoiled for choice. Yet white refined granulated
sugar is a commodity, virtually identical across brand names.
At first glance, ESG ETFs can seem the same. However, they can differ from each
other materially, with significant variations in selection criteria, tracking
error and performance.
The asset management industry is often accused of being commoditized, offering
little differentiation between investment products. While we refute the charge,
the proliferation of products in recent years makes the conclusion
understandable – particularly when it comes to passive investing.
With this in mind, we decided to take a closer look at the major ETFs to see how
they differed from their traditional benchmark counterparts in terms of
exposure, tracking error and – by inference – performance. And while index funds
replicate their benchmark exactly, many active funds use a benchmark index
portfolio to identify the investment universe. This analysis is therefore of
relevance to both active and passive investors as active funds are often merely
subsets of the index.
TRACKING THE ERRORS
Table 1 below shows that many indexes used by popular ETFs tend to have high
diversification and a close relationship with their traditional versions. For
example, even in the turbulent twelve months ending March 2023, the MSCI USA ESG
Select Index had a beta of 1.02 and a correlation of 100% with the traditional
MSCI USA Index; its tracking error was also below 2.29%.
The MSCI USA Select has limited exclusion (e.g., cluster weapons manufacturers)
and some overweighting of high ESG-rated stocks, but with the objective of
matching performance with the traditional index. This makes it what we call a
‘conventional ESG index’; such indexes seem more relevant to investors with a
preference to avoid the most common activity-based exclusions and have a
slightly higher ESG-rated portfolio profile.
We can also see that the MSCI USA Leaders Index has slightly lower beta,
slightly lower correlation and a tracking error close to 3%, compared to 2% for
the Select index. This confirms MSCI’s index description, as the index
overweights companies with high ESG ratings and excludes most of the laggards.
More negative screening (exclusion) and more positive screening (overweight of
highly-rated stocks) leads to higher tracking error and more discrepancy in
performance between the ESG and the traditional index. The Leaders index
therefore seems more relevant to investors with a preference to have a
significantly better ESG-rated portfolio.
TABLE 1: A COMPARISON OF SOME OF THE LARGEST US-LISTED ETFS TO THEIR RESPECTIVE
TRADITIONAL INDEXES
ESG Index Name
ESG Index Name
Traditional Benchmark
Traditional Benchmark
Beta to Benchmark
Beta to Benchmark
Correlation to Benchmark
Correlation to Benchmark
Tracking Error
Tracking Error
ESG Index Name
MSCI USA ESG Select
Traditional Benchmark
MSCI USA
Beta to Benchmark
1.02
Correlation to Benchmark
100%
Tracking Error
2.29%
ESG Index Name
MSCI USA ESG Leaders
Traditional Benchmark
MSCI USA
Beta to Benchmark
1
Correlation to Benchmark
99%
Tracking Error
3.10%
ESG Index Name
MSCI KLD 400 Social
Traditional Benchmark
MSCI USA
Beta to Benchmark
1.03
Correlation to Benchmark
99%
Tracking Error
3.15%
ESG Index Name
FTSE US All Cap ESG
Traditional Benchmark
FTSE US All Cap
Beta to Benchmark
1.05
Correlation to Benchmark
100%
Tracking Error
2.46%
ESG Index Name
NASDAQ Clean Edge Green Energy
Traditional Benchmark
NASDAQ 100 / MSCI USA
Beta to Benchmark
1.28 / 1.35
Correlation to Benchmark
93% / 90%
Tracking Error
13.39% / 16.82%
Source: MSCI, FTSE, NASDAQ; UBS Asset Management. For illustration only. It is
not possible to invest in indexes directly. Data as of March 2023.
CALCULATING ESG EXPOSURES
For investors with strong ESG preferences it is reasonable to ask: How much ESG
exposure is achieved by tracking some of the most popular ESG indexes? For the
different ESG dimensions, MSCI provides scores on a scale from 0 to 10, where 0
is the worst and 10 is the best possible score.1
TABLE 2: US ESG ETFS: SUSTAINABILITY SCORES
Index
Index
MSCI ESG Score
MSCI ESG Score
MSCI E Score
MSCI E Score
MSCI G Score
MSCI G Score
MSCI S Score
MSCI S Score
Index
MSCI USA ESG Select
MSCI ESG Score
8.3
MSCI E Score
7.08
MSCI G Score
6.04
MSCI S Score
6.02
Index
MSCI USA ESG Leaders
MSCI ESG Score
7.52
MSCI E Score
7.27
MSCI G Score
5.69
MSCI S Score
5.13
Index
MSCI KLD 400 Social
MSCI ESG Score
7.49
MSCI E Score
7.22
MSCI G Score
5.7
MSCI S Score
5.46
Index
FTSE US All Cap ESG
MSCI ESG Score
6.63
MSCI E Score
6.82
MSCI G Score
5.53
MSCI S Score
5.08
Index
NASDAQ Clean Edge Green Energy
MSCI ESG Score
6.3
MSCI E Score
6.42
MSCI G Score
5.71
MSCI S Score
4.74
Index
MSCI USA
MSCI ESG Score
6.62
MSCI E Score
6.72
MSCI G Score
5.51
MSCI S Score
5.13
Index
FTSE US
MSCI ESG Score
6.62
MSCI E Score
6.74
MSCI G Score
5.5
MSCI S Score
5.12
Index
NASDAQ
MSCI ESG Score
6.66
MSCI E Score
6.66
MSCI G Score
5.16
MSCI S Score
5.27
Source: MSCI, FTSE, NASDAQ; UBS Asset Management. Data as of March 2023.
MSCI ESG SCORE IMPROVEMENTS RELATIVE TO TRADITIONAL BENCHMARKS
In the following chart we calculate the ESG score improvements of the different
indexes relative to the respective traditional benchmark and disaggregate the E,
S and G dimensions.
The largest tilt to higher ESG score can be achieved with the MSCI USA ESG
Select Index (a 23% improvement relative to its traditional benchmark).
Interestingly, according to the MSCI methodology, moving from FTSE US Index to
the FTSE US ESG version doesn’t have a positive impact on the overall ESG
score.2
A striking result in the following chart is the ESG underperformance of the
NASDAQ Clean EDGE Green Energy vs. the NASDAQ. The large NASDAQ index weights in
information technology as well as Communication services are excluded, and, in
particular, these companies have on average very high ESG scores. Microsoft as
an example has an ESG score of 9.8 out of 10. Thus, along the ESG dimension the
NASDAQ is a tough benchmark.
Source: MSCI, FTSE, NASDAQ; UBS Asset Management. Data as of December 2022.
This bar chart highlights the underperformance of the NASDAQ Clean EDGE Green
Energy vs. the NASDAQ
There are also discrepancies among the different ESG dimensions if we look at
percentage differences.
The biggest improvement in the environmental dimension can be achieved by
switching from an MSCI USA equity allocation to an MSCI USA ESG Leaders
allocation. From the view of the governance pillar, the MSCI USA ESG Select
provides the largest improvement relative to the MSCI USA.
The benefits of moving to a conventional ESG index do seem to outweigh the
costs.
Finally, evaluating the social dimension requires a different set of questions
and analysis. The MSCI USA Select Index provides the largest improvement here.
All the major ESG indexes provide material sustainability rating improvements to
their respective traditional benchmarks on at least one of the major dimensions.
Given the large correlation between the ESG and traditional indexes as well as
the low tracking error implications of moving to one of the major ESG indexes,
the benefits of moving to a conventional ESG index do seem to outweigh the
costs. Furthermore, none of our conclusions change when using UBS Global Wealth
Management (GWM) or Sustainalytics data, although the scores are slightly lower
on average.
THE DEVIL IS IN THE DETAIL
Sustainability benchmarks may differ from their traditional counterparts
materially, or they may differ very little. Based on their preferences and
objectives, investors should carry out due diligence to understand the
implications of the benchmark for any investment product they choose.
Ultimately, higher adherence to sustainability principles is likely to bring
more tracking error due to both negative screening (exclusion of low-rated
assets) and positive screening (overweight of high-rated assets). However,
tracking error is not the only metric investors need to consider; factor
exposures, country and industry biases, turnover for friction costs, and so on
are all important considerations too.
Sustainability principles are also different for all investors and do not
necessarily equate to simple tilting on the basis of scores from the providers
which, as a starting point, are lowly correlated. The choice of the index
provider is how much tracking error (performance discrepancy between ESG and
traditional index) to allow when producing a benchmark.
Investors in ESG benchmarks clearly need to study the details before buying.
Download the full length article here
1The overall ESG score contains metrics across all dimensions and is computed
using industry-adjusted scores. The industry-adjustment implies that achieving a
high ESG score requires investments into assets which score well relative to
sector peers. As an example, with this methodology investments into fossil fuel
companies are possible, but the investments should be focused on the best fossil
fuel companies from an ESG perspective. In line with expectations, the overall
ESG score is usually better for the ESG index than for the respective
traditional benchmark with the NASDAQ Clean Edge Green Energy being an
exception.
2It is worth mentioning that MSCI is one of the many ESG rating methodologies
available. FTSE uses a different methodology, which apparently weighs different
ESG factors (that is, we expect that if we used the FTSE scores
* MID-YEAR 2023 PANORAMA
The SI Edition
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* APAC GREEN FORUM 2023
APAC Green Forum
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BENCHMARKING ESG
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About the authors
* MICHELE GAMBERA
Co-Head of Strategic Asset Allocation Modeling
Michele Gambera is Co-Head of Strategic Asset Allocation Modeling at UBS
Asset Management. Joined UBS AM in 2010 from Ibbotson Associates as Senior
Research Consultant and Chief Economist. Formerly Senior Quantitative Analyst
and Chief Economist for Morningstar Associates ULC. Previous experience at
Federal Reserve Bank of Chicago. Strong academic background, including
teaching Master of quantitative finance at the University of Illinois.
Frequently quoted by press outlets. Member of the Chicago Quantitative
Alliance and CFA Society of Chicago.
* RYAN PRIMMER
Head of Investment Solutions
Ryan oversees UBS Investment Solutions, including Asset Allocation, Portfolio
Management, Implementation, Analytics, and Modelling teams. Ryan rejoined UBS
in June 2018 from KCG Holdings, holding roles like Head of Quantitative and
Systematic Trading, and Head of Global Quantitative Strategies. At UBS
(1991-2013), he held leadership roles including Global Head of Equities
Trading, Global Head of Equities Proprietary Trading, and Head of SNB
StabFund Investment Management managing distressed mortgage assets.
* ALEXANDER EISELE
Quant Analyst - Investment Solutions
Alexander Eisele is a finance professional with diverse expertise. He holds
an economics degree from the University of Augsburg and a Master’s degree
from Ludwig-Maximilians-Universitat Munchen. He developed analytical skills
using Bloomberg and Datastream at Unicredi before earning a PH.D. in Finance
from USI Universita Della Svizzera italiana. At Swiss Finance Institute he
spent 5 years as a researcher, focusing on asset pricing and alternative
investment strategies. Now at UBS-AM, Alexander specializes in analytics and
quantitative modeling.
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