ESG Indexes Lifted by Carbon-Efficient Firms but Underperformed

• MSCI ACWI ESG Indexes outperformed on an annual basis for most years between 2013 and 2021 but underperformed during the first three quarters of 2022.
• While allocations to carbon-efficient companies within each sector contributed to performance, exclusions from the MSCI ACWI ESG Leaders Index due to ongoing ESG controversies detracted from performance.
• The third quarter was characterized by change of direction in the performance of industry factors, especially energy and aerospace and defense. This led to reducing the industry contribution of the MSCI ACWI ESG Indexes.

In previous research, we talked about the resilience exhibited by MSCI ESG Indexes. The exhibit below shows that during the common history for the MSCI ACWI ESG Indexes, when the MSCI ACWI Index had negative calendarized returns (2015 and 2018), the MSCI ACWI ESG Indexes fared relatively better. And during the years when global markets had positive returns, the MSCI ACWI ESG Indexes generally outperformed. However, the five flagship MSCI ACWI ESG Indexes have struggled this year along with the MSCI ACWI Index.

Historical ESG index performance

Calendarized gross returns for the period ending Sept. 30, 2022. Returns are cumulative for periods shorter than the year. YTD returns are between Dec. 30, 2021, and Sept. 30, 2022. Q3 returns are between June 30, 2022, and Sept. 30, 2022.

Dollar strengthening and exclusions were detractors

Financial market volatility, interest rate hikes, geopolitical turmoil and a strong U.S. dollar dominated the headlines in the third quarter. This environment negatively impacted the five MSCI ACWI ESG Indexes during the quarter, as it did for the first half of the year, although the underlying performance drivers for each period were different.

The indexes currently have a small negative active U.S. allocation, and the recent period of dollar strengthening generated a negative currency contribution (as shown below). While allocations to the ESG factor didn’t generate a positive contribution this quarter, the contribution from allocations to carbon-efficient companies within each sector was positive. But the negative contribution driven by stock-specific exclusions significantly contributed to underperformance.

Active factor-based performance attribution

Active factor-return attribution for MSCI ACWI ESG Indexes for the first half and the third quarter of 2022. Between Dec. 31, 2021, and June 30, 2022, for the first and second quarters. Between June 30, 2022, and Sept. 30, 2022, for third quarter.

The impact of exclusions

The specific-return contribution during this quarter was significantly negative for the MSCI ACWI ESG Indexes in the third quarter, and especially so for the MSCI ACWI ESG Leaders Index, which targets the most highly-rated ESG companies within each sector. The index also excludes companies due to their ongoing ESG controversies, which significantly contributed to its underperformance.

The four largest holdings of the MSCI ACWI Index (Apple Inc., Microsoft Corp., Amazon.com Inc. and Alphabet Inc.) accounted for more than 12% of the index by weight as of Sept. 30, 2022, and contributed more than half of the negative specific return of the MSCI ACWI ESG Leaders Index. ¹Both Apple and Amazon were excluded from the MSCI ACWI ESG Indexes due to their involvement in ongoing controversies related to their customers, governance, the environment and human rights. Companies like Microsoft and Alphabet were MSCI ACWI ESG Leaders Index constituents during the second quarter, but continued to underperform and detract from performance in the third quarter.

Top four constituents, performance and inclusion

Data between June 30, 2022, to Sept. 30, 2022.

Industry allocation played a lesser role

In a divergence from the first two quarters of the year when industry factors had sizeable returns, we saw a reversal in performance in the third quarter, especially for energy and aerospace and defense.

The MSC ACWI ESG Indexes are constructed to avoid significant Global Industry Classification Standard (GICS®)² sector exposures, which historically have led to insignificant active industry exposures. We saw earlier this year how substantial energy-sector returns of industries in the energy sector resulted in significant active return contributions, but this was not the case in the third quarter. We review the performance of MSCI Global Equity Factor Model industry factors and ESG exposures for the third quarter below.

Top and bottom industry factors performance and ESG exposure

Factor performance of select top and bottom industries using the MSCI Global Equity Factor Model risk model. Data between June 30, 2022, to Sept. 30, 2022, for the third quarter. Data between Dec. 31, 2021, to June 30, 2022, for the first and second quarters. All exposures are not economically significant. Exposures between -0.005 and 0.005, are marked as ° indicating neutral exposure, + and – indicate exposures between 0.005 and 0.075 and -0.060 and -0.005.

Oil and gas exploration and production, as well as oil and gas and consumable fuels industry factors, went from high positive values in the first and second quarters to a significant negative in the third quarter. Aerospace and defense, together with integrated oil and gas industry factors reversed their performance from positive to negative as well. Some of these changes could be attributed to the second wave of the energy price-run effect that impacted energy-consumption-intensive companies. This performance shift led to an overall impact of industries on the active performance of the MSCI ACWI ESG Indexes from substantial during the first half of the year to insignificant this quarter.

Energy powering down?

It remains to be seen how each of the flagship indexes will close the year, as the effects of the energy outperformance detracted less in the third quarter than the first half of the year. The MSCI ACWI ESG Indexes have historically exhibited resilience, but dollar strengthening and exclusions of some large companies played a significant role in ESG indexes underperformance in the third quarter. Nonetheless, allocations to carbon-efficient companies within each sector continued to positively contribute to performance.

¹Long-term specific return contribution to MSCI ACWI ESG Leaders Index performance was -0.13% between Nov. 20, 2012, and June 30, 2022.

²GICS, the global industry classification standard jointly developed by MSCI and Standard & Poor’s.

Further Reading

Despite Energy Outperformance, Climate Indexes Were Resilient

MSCI ESG Indexes Underperformed but Met ESG Objectives

Monthly Equity ESG Insights