The new analysis, which examined MSCI ESG-rated large- and mid-cap companies in developed markets over the ratings’ 17-year history and, combined with emerging markets, over 11 years ended Dec. 29, 2023, shows that positive exposure to higher ESG-rated issuers improved financial performance before and after controlling for region, size, sector and traditional factor exposures (Exhibit 1).
It also validates MSCI ESG Ratings’ focus on financial materiality. The analysis suggests that while ESG ratings in the marketplace vary widely, with some aiming to capture objectives beyond financially relevant factors, measuring companies’ exposure to (and management of) financially relevant, industry-specific risks according to MSCI’s ESG Ratings methodology has helped investors identify firms that have outperformed the market on a risk-adjusted basis.
Quintiles are created every month based on adjusted scores: Pillar scores are first z-scored by Global Industry Classification Standard (GICS®) sector and region (North America, Europe, Pacific and EM sub-indexes of the MSCI ACWI Index) and then size-adjusted. For industry-adjusted ESG scores, we controlled for size and region bias. The next month’s performance (in local return) of the quintiles is calculated. The graph shows the cumulative difference between the top and bottom quintiles’ performance. Data from Dec. 31, 2012, to Dec. 29, 2023. Source: MSCI ESG Research.
While investors differ in their opinions as to which E, S and G issues matter most for corporate performance, the analysis continues to show value from the combination. “Overall, the results indicate that the industry-specific aggregation of E, S and G key issues has added financial value and consistent outperformance over time,” write my colleagues Guido Giese and Drashti Shah, who co-authored the analysis. “It is worth highlighting that while all three pillars — E, S and G — showed a positive performance effect over the study period, their aggregate scores showed the strongest performance effect.” (Exhibit 2)
Quintiles are created every month based on adjusted scores: Industry-adjusted ESGs scores are size-adjusted and quintiles are created per region (North America, Europe and Pacific sub-indexes of the MSCI World Index). The next month’s performance (in local return) of the quintiles is calculated. The graph shows the cumulative difference between the top and bottom quintiles’ performance. Data from Dec. 29, 2006, to Dec. 29, 2023. Source: MSCI ESG Research
The findings add to research in which we have shown that selection and weighting of key ESG risks industry by industry (as MSCI’s ESG Ratings methodology specifies) has better captured companies’ exposure to dynamic and emerging risks than a hypothetical ESG-rating methodology that simply weights E, S and G pillar sores for each company in the rating equally.
My colleagues also extend previous research on the relationship between the ESG factor and traditional equity factors — specifically its positive correlation to quality and residual volatility — in accounting for performance. In this new research, they demonstrate that the ESG factor as reflected in the MSCI Barra factor model (MSCI GEMLT ESG model) showed cumulative positive performance over the study period that cannot be explained by traditional equity factor exposures.
At the same time, it is just as important to note that the ESG factor performance showed volatility, with some very strong performance years, such as in 2019 and 2020, and some years showing underperformance (e.g., 2015 and 2023). In other words, no factor outperforms under all market conditions. ESG is no exception.
Outperformance during crises
The COVID-19 pandemic in 2020 and the start of the Russian-Ukraine War in 2022 presented MSCI ESG Ratings with two major risk events. “During both crises, positive exposure to companies with higher MSCI ESG Ratings (all other factors being controlled for) added financial performance,” note the authors.
The extent of outperformance differed, however. Notably, in the pandemic, the return that is attributed to the ESG factor, net of traditional factors such as volatility or momentum, was higher than in any of the other years of the study period. That positive effect was more muted in the second crisis: During the outbreak of the war, the ESG factor was positive but below the 11-year average.
Addressing questions about performance: industry and valuation
I am frequently asked two questions about what can explain the positive or negative performance from MSCI ESG Ratings. One is very simple to answer. The other has required a longer track record of observed behavior.
The first is whether positive and negative performance is driven by the ups and downs of the energy or tech sectors. This question is typically asked by those who are not familiar with MSCI ESG Ratings, as the ratings are by design industry-relative. That means there are highly rated and lowly rated companies in every industry, including oil and gas, health care and technology. Hence, the outperformance of higher-rated companies cannot be accounted for by a “green” industry having the preponderance of highly rated companies and a “brown” industry having the preponderance of lowly rated companies.
My colleagues examined the differences between sectors and added an interesting twist to understanding the performance differences within the three carbon-intensive sectors of utilities, materials and energy. They found that while companies with high MSCI ESG Ratings in these carbon-intensive sectors outperformed in the developed markets, they underperformed in the emerging markets.
The authors speculate that differences between developed and emerging markets in the transition away from fossil fuels and the continuing expansion in emerging markets of the use of coal for energy production may be one possible explanation.
The second question is whether MSCI ESG Ratings’ positive performance reflects fashion or crowding; that is, whether as investments have flowed into ESG-oriented funds in recent years, higher MSCI ESG-rated companies became more highly valued and potentially overpriced.
In this new analysis, my colleagues used the additional years of data to extend previous research on this question. They confirmed that between 2013 and 2023, the outperformance of companies with higher MSCI ESG Ratings was led by earnings growth, rather than by an expansion of price-to-earnings (P/E). In fact, they found that the companies with higher MSCI ESG Ratings have been growing their earnings, per unit of market cap, faster than lower-rated companies.
None of this suggests that past performance indicates future results. But as investors refine and evolve their unique approaches to integrating ESG considerations, it is important to learn from historical results of one consistent approach. Both a 17-year history with developed-market companies and the 11-year history that includes emerging-market companies have shown that a consistent approach to combining ESG attributes that are industry-specific and financially-material has produced outperformance before and after controlling for region, size and equity style-factor exposures.
Contrary to popular conjecture, the outperformance of MSCI ESG Ratings was not due either to an industry skew toward the tech sector or to increasing valuation levels. But confirming a now-prevalent view, companies with stronger management of financially material ESG issues showed greater resilience and outperformance during the two recent crises of the COVID-19 pandemic and the onset of the Russia-Ukraine war.
