Japan GPIF Changes ESG Domestic Equities Index Due to ‘Large Tracking Error’

Japan’s Government Pension Investment Fund has moved approximately $20 billion to a new environmental, social and governance-themed domestic equities index due to concerns over a “large tracking error” with its previous one, the $1.7 trillion pension giant revealed in its ESG report for fiscal 2023.

The GPIF transferred approximately 3 trillion yen ($20.1 billion) from the MSCI Japan ESG Select Leaders Index, which it adopted in 2017, to the MSCI Nihonkabu ESG Select Leaders Index, which was launched earlier this year. According to the report, the aim was “to reduce the risk of tracking error from TOPIX, the policy benchmark, while retaining the basic characteristic of an ESG index.”

According to the pension fund, the tracking error in the previous index was mainly due to its inclusion of Japanese real estate investment trusts, which the GPIF’s policy benchmark does not, and because it is biased toward large-cap stocks. Following “many discussions” with MSCI, according to the pension fund, the index provider proposed a new index with new inclusion criteria that include the top 50% of ESG-rated stocks within a given industry, rather than stocks with the highest ESG ratings through 50% of market capitalization, as the previous index does.

The MSCI Nihonkabu ESG Select Leaders Index, which includes 508 constituents, is described by MSCI as a free-float-adjusted market capitalization-weighted index that aims to reflect the performance of companies chosen from the MSCI Nihonkabu Investable Market Index based on ESG criteria. The criteria exclude constituents based on involvement in specific business activities, as well as ESG ratings and exposure to “ESG controversies.” More than half of the index is weighted to the industrials (25.2%), consumer discretionary (16.88%) and information technology (14.55%) sectors.

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The pension fund also announced in the report that the return rates from ESG indexes for Japanese domestic equities exceeded both the parent indexes and the market average during the fiscal year, while some foreign equities ESG indexes underperformed both their parent indexes and the market average. However, it added that, since inception, the ESG indexes for both domestic and foreign equities have “generally outperformed” both the parent index and the market average.

The GPIF also reported that the cumulative excess returns of ESG passive domestic equities funds over the market average and parent index were 124.2 billion yen and 64.3 billion yen, respectively, adding that the “benchmark effect” increased in the 12 months after March 2023, while the “fund effect” turned negative in March 2020 and has moved slightly lower since then.

The GPIF defines the “benchmark effect” as the difference between the return of an ESG index and the parent index and market average, while the “fund effect” is the difference between the return of an ESG passive fund and an ESG index.