Sustainable investing, which considers environmental, social, and governance (ESG) opportunities and risks in portfolio construction, has evolved far beyond its origins as a niche concept. As a result, the demand for benchmarks that incorporate ESG has grown over time. Various indices have emerged as important tools for the integration of ESG considerations into investment decisions and performance. Old Mutual Investment Group has been tracking and managing strategies linked to these indices for more than a decade, building deep experience across a diverse range of global equity mandates and index approaches.
These global ESG-focused indices generally try to capture the performance and risk characteristics of a global broad market cap index while also trying to achieve sustainability or reward companies that have better sustainable practices. The first sustainable index was launched in 1990, and today it is estimated that there are well over 50 000 ESG indices. This growth has been driven by regulation and investor preferences over time. What has also happened during this time is that ESG indices have transitioned from simple screening-based products to portfolio construction tools that seek to improve sustainability outcomes while preserving the risk-return characteristics of broad market benchmarks. Because the broad market cap index provides the foundation for sustainable indices, we must be cognisant of how they have evolved to better understand how ESG indices continue to evolve.
We recently adopted the MSCI Focus Indexes, which are designed to maximise ESG exposure through optimisation for higher sustainability scores while maintaining sector diversification and a tight tracking error against a parent index. They differ from the MSCI Selection Indexes, which use a rules-based, best-in-class approach (relative approach to selecting companies), offering a selection of top-rated companies within sectors.
While both approaches aim to improve the sustainability profile of a portfolio, they differ in portfolio construction and how they manage risk. For investors seeking sustainable equity exposure, an optimal approach is to utilise sustainability indices that maintain broad and balanced global market representation while actively controlling risk relative to the parent benchmark. By incorporating optimisation techniques, the MSCI Focus Indexes can better manage unintended sector and style tilts, reduce concentration risk, and limit overexposure to individual holdings.
Why this matters
As traditional equity benchmarks have evolved alongside a changing market landscape, they have become increasingly concentrated in a few dominant regions, countries, and sectors. Because ESG overlays inherit these underlying benchmark traits, understanding this structural shift is crucial to seeing why modern sustainable mandates require a more sophisticated, risk-managed approach rather than simple exclusions.
Twenty years ago, banks, oil companies and industrials were the largest companies and sectors across the indices, with the US market accounting for roughly 40% of the global equity market. Technology was a moderate industry in size, but it was not the mammoth it is today. If you consider a company like Apple, it was in its nascent stages; the iPod was still being launched; the company looked vastly different from what it does today.
Standard global equity market cap indices, by their nature, will evolve with the global market landscape. Today, the US accounts for approximately 70% of the MSCI World Index, an index with 23 developed equity markets, and is largely concentrated in one country. Information technology and Artificial Intelligence have had a massive impact on the representation of the US in standard global equity indices; the digital economy has taken over, and companies with large intangible assets on their balance sheets have redefined how wealth is created in the current economy compared to a few decades ago.
Possible investor outcomes
The MSCI Selection Index selects the highest ESG-rated companies until approximately 50% of each sector is represented. What this means is that by excluding half of the universe without explicitly controlling the active risk, the methodology unintentionally ends up doubling the weight of companies and creates further deviations in sectors and stock weights when compared to the broad market cap index. A consequence of using fixed selection rules and having a higher number of exclusions is higher idiosyncratic risk, and index performance is influenced by a handful of stocks, which over the recent market period are tech companies.
The MSCI Focus Index, with its optimisation-based methodology, provides broader diversification, improving risk management and maximising the overall ESG rating on the index while maintaining risk and return characteristics that are like the standard market cap index. This framework makes the Focus Index more flexible, investable and fit for purpose. There is less trade-off between the integration of ESG, diversification, tracking error and investment performance.
To understand how different methodologies handle concentration, consider the constituent profiles of the broader family:
- MSCI ACWI Index: ~2 400 constituents
- MSCI ACWI Selection Index: ~1 000 constituents
- MSCI ACWI Focus Index: ~500 constituents
It may seem counterintuitive that the index that is more diversified between ACWI Selection and ACWI Focus is the latter, given that it has fewer constituents. To assess how diversified an index is, we must use the measures that quantify portfolio concentration, such as the effective number of stocks, which indicates how many of the stocks in the index are driving performance or volatility outcomes, and the Herfindahl-Hirschman Index (HHI). A lower HHI and a higher effective number of stocks indicate better diversification. As we can see, the MSCI Focus Index is superior to the MSCI Selection Index on these measures.
In conclusion
By design, market-capitalisation-weighted indices allocate a greater weight to companies with larger market values, resulting in increased exposure to securities whose weights have risen alongside their valuations. While this approach provides an efficient representation of the investable market, one of the fundamental characteristics of an effective benchmark is broad diversification across sectors, styles and individual constituents.
Although the selection index has its merits, in a market environment in which concentration levels are elevated, the methodology further amplifies exposure to dominant companies, increasing stock-specific risk. We therefore favour an optimised index approach, which results in a more diversified portfolio that delivers enhanced sustainability outcomes without significantly altering the underlying investment characteristics of the benchmark.
Our offering
At Old Mutual Investment Group, we offer a comprehensive range of capabilities that span cap-weighted, smart beta and thematic indices. These indices are constructed using different methodologies, enabling investor access to the global equity market. Our track record in the global space dates back to 2009. Within the ESG ambit, we have managed the World Selection and Emerging Markets Selection indices since 2013 and 2015, respectively. These indices were recently transitioned to MSCI Focus indices after a comprehensive review. We also offer the RAFI Global Select 3000 Index, the MSCI ACWI Quality and ACWI Growth EU CTB Index/es, which form part of our Smart beta product set, and the MSCI World Index, which we recently launched.