Climate stress-testing models like MSCI Climate VaR may be complex, but their main mechanisms can be explained using linear regression. This helps transform input variables into risk outputs, making it easier for investors to understand the primary drivers.  

Our previous research discussed a framework for investors to attribute changes in equity portfolios’ emissions to their primary drivers. We now adapt it to identify and analyze two approaches to tracking a multi-asset-class portfolio’s carbon footprint. 

Several factors can drive the changes in a corporate-bond portfolio’s emissions. Our framework helps disentangle these variables and provides investors with greater clarity into their climate-aware strategies. 

Tracking a portfolio’s carbon footprint can be challenging given the multiple drivers of changes in emissions. Our framework attributes these changes to their primary drivers, including changes in issuers’ emissions, ownership and financing structure.

We present a framework that allows investors to understand to what extent changes in a portfolio’s carbon footprint are due to companies’ real-world decarbonization efforts, a portfolio manager’s investment decisions or changes in companies’ financing.

Following extensive research showing an improvement in risk-adjusted returns for companies with higher ESG ratings, we look beyond what a company’s ESG issues were to how that company dealt with them — and the impact that had on stock-specific risk.

Our analysis of ESG factor performance in 2022 suggests that time horizons, as well as specific sectors and regions, may be significant in assessing the return characteristics of ESG portfolios. 

With no “one fits all” solution, to help investors identify the most suitable climate metrics, we take an in-depth look at MSCI ESG Research’s climate metrics in terms of what they measure, how they are calculated and their potential use cases. 

Time horizons are key to understanding the impact of environmental, social and governance on stock returns. This paper, which was published in Investments & Wealth Monitor, illustrates the relative importance of event risk vs. erosion risks over time.

Investors can use different metrics to track their portfolios’ carbon footprint. Regardless, they will increasingly need tools to better identify the sources of changes in whichever climate metrics they use. We present an attribution methodology.

Europe’s search for energy sources outside of Russia may slow the low-carbon transition in the short term. Staying within a net-zero cumulative emissions budget would mean fewer emissions later. What might this path mean for investors’ portfolios?

Investors may want to understand not only if their portfolios are aligned with global climate goals but why they may (or may not) fall short of the mark. A performance-attribution analysis can help them understand how “hot” or “cold” their portfolios are.

ESG ratings are widely used in active management and ESG indexes, with a growing focus on climate change. This has increased debate around two questions: Why are ESG ratings so different across providers? And how do ESG ratings reflect climate risk?

While investors around the world are committing to bring the carbon footprints of their portfolios to net-zero by 2050, figuring out how to do so is not a simple matter. What alternatives do investors have?

Investors have a key role in keeping global warming well below 2°C. We examine four strategic levers that investors can use to accelerate companies’ decarbonization: a shift of capital, active stewardship, financing of low-carbon solutions and policy advocacy. 

To what extent has climate risk been priced into equity markets? How can we model such risks as the world moves toward net-zero targets? We show how climate has increased in importance in the last two years, with potential long-term implications for understanding equity markets.

How are environmental, social and governance (ESG) ratings constructed? Which indicators are the most important in assessing ESG characteristics? Does the answer vary by sector? This foundational paper examines the impact on financial performance of two types of ESG indicators: the individual E, S and G pillars scores and the underlying ESG Key Issue scores.  

To what extent has climate risk been priced into equity markets? Is there a “brown” discount and a “green” premium? Has this shifted over time? How can we model such risks as the world moves toward net-zero targets? We examine the financial impact of climate transition risk on global equity markets.

As the COVID-19 crisis affected financial markets, all standard MSCI ACWI ESG equity indexes outperformed their market-capitalization benchmarks. Where has this outperformance come from? Have inflows into ESG investments driven up equity valuations, possibly creating a price bubble?

As we’ve previously demonstrated, incorporating firm-level ESG characteristics into portfolio construction can preserve, and even improve, risk and return relative to the broad market. Here we follow-up by asking how an allocator can integrate ESG considerations efficiently across multiple portfolios in its equity program.

Inflows into ESG funds have soared in recent years and months, in part motivated by outperformance since the COVID-19 pandemic erupted. But have these inflows become a self-fulfilling prophecy, creating an ESG bubble?

How one combines environmental, social and governance scores into an overall ESG rating can have a significant impact on its usefulness to investors. We tested two approaches: equal weighting and backward optimization. The results suggest that investors proceed with caution. As published in The Journal of Impact & ESG Investing.

Our recent research suggests that environmental and social issues were more industry specific and tended to show up in financial measures over a longer time frame compared to governance issues. How can E, S and G issues be combined?

How can active managers integrate climate risk in their portfolios? We test four simple exclusion strategies on a sample global equity portfolio, examining their impact on the risk, return and market exposures.

Very different ESG issues can be material for different industries. Our research suggests that risks can be divided into two main types: “event” risks and “erosion” risks to companies’ long-term competitiveness. Which ones mattered most for E, S and G?

The conventional wisdom has it that governance is the most dominant of the three E, S and G pillars. But our analysis finds different results when looking at contribution to performance over different time horizons.

The coronavirus pandemic sparked a surge of volatility across global financial markets. What lessons could investors draw from the COVID-19 crisis? In this paper, we present and discuss empirical evidence supporting five key lessons for investors regarding global investing, managing factors, active management, indexed investing and ESG investing.

The COVID-19 outbreak is the first real-world test since the 2008 global financial crisis of the resilience of companies with high MSCI ESG Ratings. We analyze the performance of four standard MSCI ESG Indexes over Q1 2020 and longer periods.

Recent MSCI studies have shown historical positive correlation between environmental, social and governance considerations and corporate financial performance. Has this pattern held in emerging-market equities?

Many researchers have studied the link between companies’ Environmental, Social and Governance (ESG) characteristics and financial risk and performance. This paper examines some of the underlying economic questions: How have markets priced ESG characteristics? Have they been fully priced? Have there been sweetspots? How quickly did the market incorporate ESG information? We investigate these questions by looking into how changes in companies’ ESG profiles have historically predicted equity...

Asset owners use indexes as policy benchmarks and reference portfolios in their asset allocation. Index investors track cap-weighted indexes that seek to capture the market return. 

Despite strong headwinds, including renewed divestment pressure,1 the tobacco industry has proved quite resilient financially and outperformed the stock market over the past 18-1/2 years. So much so, that some institutional investors are now thinking of lifting tobacco bans in their investment policies. We found that most of the gains associated with holding tobacco stocks over this period were not specific to the tobacco industry, and could have been obtained in other ways. We also show it...

How can ESG characteristics be integrated consistently across factor-based and active equity allocations? In Part 4 of the Foundations of ESG Investing paper, we discuss two approaches to applying ESG ratings to factor-based allocations – a one-step and a two-step approach – asking which has done a better job at combining the underlying strategy with ESG while maintaining exposure to target factors. We then investigate overlaying ESG ratings and ESG momentum on the historical holdings of...

According to recent surveys, asset owners’ have shifted their main focus to ESG’s financial benefits, as opposed to social benefits. In the third part of this paper, we discuss how ESG can be integrated into indexed allocations using MSCI ESG Ratings, which provided better risk-adjusted returns from August 2010 to December 2017 than the MSCI ACWI Index. We used existing best-in-class selection-based index methodologies (the MSCI ESG Leaders Index) for the creation of hypothetical global and...

Many studies have focused on the relationship between companies with strong ESG characteristics and corporate financial performance.  However, these have often struggled to show that positive correlations — when produced — can in fact explain the behavior. This paper provides a  link between ESG information and the valuation and performance of companies, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile...

A Study of Three Portfolio Strategies The broad effects of excluding entire business lines, typical of the more traditional values-aligned of a socially responsible portfolio, are generally understood. However, little research has been done on the performance implications of exclusions based on alleged corporate wrongdoing, though such exclusions are common. In this study, we investigate the risk and return impact of excluding companies involved in events negatively impacting stakeholders,...

We see a growing number of institutional investors seeking to avoid financial risks associated with environmental, social and governance (ESG) factors, or even to enhance returns by investing in companies that have strong ESG track records. As we wrote in an earlier blog post, these investors are typically looking to limit the number of companies excluded from their portfolios, both to avoid sacrificing diversification and to be active owners able to engage with corporate management.

Integrating ESG criteria into equity portfolios raises important portfolio construction questions. For example, what is the impact of ESG on portfolio performance and characteristics? How does it alter the risk profile and the factor exposures of portfolios? How does it affect institutional investors’ ability to pursue their investment strategy?  Our results show that integrating ESG criteria into passive strategies generally improved risk-adjusted performance over the period 2007 to...

Do institutional investors sacrifice risk-adjusted returns by incorporating ESG considerations?

In this Research Insight, we present a framework for evaluating the relative accuracy of beta forecasts. We consider naive betas, historical betas, and predicted betas. Our technique relies on observing the residual returns of a large universe of stocks over various time periods. We find that the expected residual volatility decreases as the beta estimates become more accurate. We also demonstrate residual volatilities can be translated into beta estimation errors. We find that across the...

In this Global Market Report, we examine the latest developments in emerging markets through the lens of the Barra Emerging Markets Equity Model (EMM1), a risk model tailored for this specific investment universe. We examine whether there has been a change recently in the strength of industries and countries. We are also able to gauge how the inclusion of style factors modified the overall picture.

In this Research Insight, we use the Barra Emerging Markets Model (EMM1) and the Barra Global Equity Model (GEM3) to attribute the returns of a representative set of emerging market portfolios.  We show that by aligning the estimation universe with the investment universe, the EMM1 model provides a more accurate and meaningful description of emerging market portfolios.

Since the outbreak of the global financial crisis in 2008, global mid-cap stocks have been unique, providing a better risk-adjusted return than a combination of large and small-cap stocks.  Recent global trends, such as low interest rates, decreasing risk aversion and the availability of cash for acquisitions, may have favored the outperformance of mid-cap stocks.  In this Europe Market Report, we look at this trend through the lens of the Barra Europe Equity Model (EUE4) and...

In this Europe Market Report, we investigate the relative importance of industries and countries in Developed Europe, using a case study with the EUE4 Model. In particular, we explore whether the recent sovereign-debt crisis had altered the relative importance of these two sets of variables.  We find that since the late 1990s, industries have dominated countries in Developed Europe. As the sovereign-debt crisis unfolded in 2011, the gap between the two narrowed, although countries never...

For years, practitioners have debated the benefits of using fundamental versus statistical models. In this Research Insight, we argue that the two approaches to risk modeling are complementary, not mutually exclusive. To support our reasoning, we provide a case study that demonstrates how the Barra North America Stochastic Factor Model (NAMS1) and the Barra US Equity Model (USE4) can work in concert to uncover hidden sources of risk.

In this Model Insight, we investigate whether statistical models can capture sources of risk that are missing from a fundamental factor model. We also study whether statistical models are more effective at detecting missing factors during periods of market turmoil.  We conclude that the statistical model effectively identified sources of risk that were missing from a fundamental model. Furthermore, we show that the strength of these missing factors peaked during times of market...

In this report, we look at the period between January 1997 and December 2012, comparing two methods of estimating the market risk of a portfolio: historical beta and predicted beta, based on the Barra Global Equity Model (GEM3). We investigate this question: which estimation approach performed best during periods of market stress? We find that during our sample period, predicted beta appears to be a more accurate than historical beta as a gauge of the defensiveness or aggressiveness of a...

Pure factor portfolios have unit exposure to the particular factor, and zero exposure to all other factors. Such portfolios, however, are not uniquely specified because they depend on the regression weighting scheme used for their construction. In this Research Insight, we investigate the risk and return characteristics of pure factor portfolios under several different regression weighting schemes.

In this paper, we show how Barra models capture the risk and return characteristics of mid-cap stocks using the Non-Linear Size factor. This factor describes the return difference between mid-cap stocks and the overall market, net other factors. We show that since the global financial crisis of 2008, the impressive performance of global mid-caps was attributed, in large part, to their exposure to Non-Linear Size. Monitoring the exposure to this factor provides investors with a view of...

This report analyzes USE4 factor returns during different volatility regimes during the last 17 years, with a focus on regimes with rapidly increasing volatility. Although these regimes were often associated with a decline in equity prices, some style and industry factors offered a hedge during these periods. Among styles: Momentum, Dividend Yield and Earnings Yield performed well in this environment. Among industry factors: Health Care, Utilities, and Consumer...

The crisis in the European sovereign bond and equity markets that started in late 2009 is still not resolved. As European economies and the local equity markets form a strongly connected network, the whole region – including core countries – is exposed to potential negative developments in Greece, Portugal, Spain, Ireland, and Italy. In this report, we show how the Barra Europe Equity model (EUE3) can be used to help identify stocks that are less sensitive to the unfavorable...

Some portfolio managers think of REITs as a source of good returns, having low correlation with the broad equity market. This market report examines these claims by looking at sources of outperformance as well as sources of return, risk and correlation over the past five years. Using the Barra US Equity model (USE4), we show that recent REIT performance was mainly due to an industry effect; over the long run, exposures to style factors heavily influenced the return and risk of a REIT...

The 2008 financial crisis put global markets into a volatile “risk-on / risk-off” swing.  When investors worry about recession or deflation, their risk aversion goes up and they shift to low-risk assets, thus hurting risky assets like equities. In contrast, when investors expect a recovery or inflation, their risk aversion goes down and they shift into high-risk assets.  This binary attitude results in a high degree of correlation among global markets and may point to a...

The Facebook IPO raises questions about both the stock’s valuation and its risk characteristics. In this report, we explore how including or exluding  Facebook might affect the risk of style, or size segment portfolios of US equities. We also explain how the USE4 Model estimates factor exposures and specific risk of stocks before and after their IPO. For Facebook, we provide an estimation of those risk numbers, which can be used to create proxy assets in Barra Aegis or Barra...

According to popular index-based measures, value stocks have tended to underperform growth stocks since 2010.  Alternative measures  of the value effect have shown different return profiles. In this report, we compare these different measures while touching on the practical issues of value investing, illustrating how unintended biases in a portfolio designed to capture the value effect could strongly influence its performance. 

US investors are bracing themselves for the potential expiration of the 2003 Bush dividend tax cut.  To help portfolio managers prepare for this potential change in the US tax code, this Market Report uses the rich factor structure of the Barra US Equity Model to examine these issues: (1) what effect the initial tax cut had on dividend-paying stocks, (2) the impact of this policy on the overall stock market, and (3) the change in dividend policies of the issuing firms. 

In this paper, we examine the role of real estate in a multi-asset class institutional portfolio that adopts an objectives-driven asset allocation framework. We show that real estate may serve a variety of functions in an institutional investor's portfolio and should not be treated as a homogeneous asset class. Instead, the appropriate type of investment should be aligned with the total plan goals, with a focus on evaluating different real estate investments for their ability to add value to...

Sector rotation strategies are a staple of finance textbooks. This paper discusses sector rotation strategies and contributes beyond the typical literature by highlighting the need to look at the style profile within each sector. Most of the earlier studies on sector rotation focus on the links between industry membership and the macroeconomic or market cycles. We find that style exposures play an important role in sector performance, and returns driven by style effects can dominate returns...

In this bulletin, we examine the effects of an alternative global index weighting scheme that weights countries in a regional index by their GDP. This strategy has led  to a superior performance of the MSCI All Country World, MSCI World, and MSCI Emerging Markets GDP Weighted Indices in the past 40 years, when compared to their market capitalization weighted counterparts. We also list possible reasons that could explain this historical outperformance.

We analyze components of long run returns of international equity markets using historical data spanning the 1975-2009 period. The analysis shows that after inflation, dividend income was the most important part of equity returns for the majority of markets. Growth in real book value had a low, but steady contribution to performance. Changes in valuation tended to smooth out in the long run, but had important implications to equity investing in the short run. We also show how expectations of...