How easy is it to switch to an ESG aligned passive fund?

Published by Kimberley Fisher on

Estimated reading time: 8 minutes

Part of the “What does a 1.5 degree portfolio look like?” blog and webinar series

What would it have taken to add 0.5%p.a. to your returns over the last five years, or put another way, how beneficial would an extra 0.6% have been over Q1 2020?  

The Environmental, Social, and Governance (ESG) debate focuses on the benefit to the planet and society of adopting change. It’s the right thing to do.  For those responsible for the stewardship of their pension schemes it has also enhanced returns. By taking an active decision to move to a more ESG aligned index tracking, investors could have seen both of the above benefits without taking on any active manager risk.

Never let the truth get in the way of a good story is the saying – so let me be clear the above is supported by fact, but it would be reckless of me to suggest that it will be like this over every period.  There is a groundswell of very informed opinion (Mark Carney is just one notable name among many) who believe it is a trend that will carry on in future.  Add to that the weight of the investment management industry with their launch of new ESG products and it is time to sit up and take more notice. 

In the sections below we discuss more on passive ESG funds, possibly the easiest first step in reducing an investor’s carbon and integrating ESG into their investment strategy. 

To begin with, let’s start with the common issue affecting any investment change, how much will it cost? The answer is less than the first year’s added return (0.5%) discussed above, and on an ongoing basis ESG passive funds tend to be a few basis points more expensive than their market cap counterparts. Would we expect that differential to reduce as ESG indices gain in usage? Yes.

Whilst switching to an ESG aligned passive fund is easy, the proliferation of ESG and climate-aware passive funds requires some thought to ensure it capture’s an investors aims. While the range of options gives investors greater capacity and freedom than ever before, this is also where they need to be careful; there is a wide range of funds captured under the ‘ESG’ umbrella, and not only the relevant index, but also the approach to engagement and stewardship, need to be considered when choosing one. This is particularly true for schemes who are looking to align their portfolio with the requirements of the UN’s Paris Agreement.

Index ESG products track a benchmark where the underlying companies are included and weighted according to ESG characteristics, rather than their size (market capitalisation). What ESG metrics are used to make the index, depends on what the index is trying to achieve. For example, some indices will focus on overweighting constituents with good ESG credentials, some will focus on excluding the worst offenders, while others focus on more specific aims such as lowering carbon exposure. 

Like equity investing itself – where there are passive, value, growth and thematic approaches to investment, ESG indices cover a broad spectrum of aims.  We discuss some of these below and the aims of the investors using them.

Climate-aware funds stray away from the market cap because a traditional market cap benchmark would mean investing in a manner that will result in a world 3.8 degrees above pre industrial levels- very out of line with the Paris Agreement, EU Green Policy and the UK policy on reaching carbon neutral by 2050. 

Benchmarks have been developed to allow investors to invest in line with the Paris agreement. We welcome the news that pooled fund access to them, is expected this summer. The majority of the passive climate-aware products available to UK institutional investors focus predominantly on carbon reduction, by excluding certain carbon intensive sectors or particularly harmful fossil fuels such as thermal coal or tar sands.

There are a number of climate-aware funds that mix being climate-aware with a factor-based approach to investing, where the index is also altered by a number of ‘factors’ or characteristics and attributes of companies such as quality or value and therefore the final weighting of the company in the final index. This factor-based approach will have a larger effect on performance than any tilting or exclusions for climate reasons. Investors should be aware of this before investing. 

We are seeing a growing trend in the number of investors considering a low-carbon or climate-aware approach to their investments.  This is based on a desire to manage the increasingly apparent risks associated with climate change or financial markets views of these risks. 

Case Study 1

We were appointed by a £400m defined contribution scheme at the end of last year, where the company is focussed on the transition to a world run on clean energy. It has therefore thrown its weight behind the fossil fuel disinvestment movement and is keen to move its pension scheme assets out of oil, coal and gas companies that it deems are polluting the planet. There are some members of the scheme who have ceased to contribute to the pension savings on account of the strength of their beliefs over this issue.

We have therefore been tasked in assisting with reducing the carbon exposure in the Scheme’s investment arrangements. This has involved working with an investment manager to create a passively-managed equity option, which this scheme will seed based on the following reductions:
 

Trustees may also wish to integrate wider ESG considerations into their passive allocations. There are a number of types of passive strategy that can be used to achieve this ESG integration:

  • ESG tilted and best-in-class: Funds may track an index which has been ‘tilted’ using ESG scores or a similar metric although they generally do have some exclusions, such as controversial weapons. These indexes will not differ too greatly from the parent index; the constituents will be largely the same and the weightings within the index will often be within a certain tolerance of the parent index. With this approach, investors may still have exposure to ‘bad’ ESG companies, albeit just a smaller exposure compared to the parent index. 
  • Best-in-class: The index will only hold companies who are ‘best-in-class’  in terms of their ESG credentials; companies who lag behind are not eligible for inclusion. Best-in-class indices are designed for investors who wish to maximise their exposure to ‘good’ ESG companies and have little to no exposure to ‘bad’ ESG companies. 
  • Exclusionary: The index will exclude stocks that are involved in industries that are incompatible with ESG investing, such as controversial weapons, tobacco and gambling. These indices might have an absolute exclusion in place (companies who make any revenue from these industries are not eligible for inclusion in the index) while others may have a revenue threshold in place (revenue is allowed from that activity up to a percentage of their total). This means a greater number of companies will be eligible for inclusion in the index

We feel that any of the above approaches is appropriate depending on what is trying to be achieved by the scheme. 

Case study 2

One of our Local Government Pension Fund clients has a strong focus on ESG within their investment portfolio. The Pension Committee for the Fund have been integrating ESG considerations into their investment decision making for many years and were one of the first Local Government Funds to divest from tobacco companies and invest in renewable energy. 

More recently we have provided the Committee with research on pooled equity funds which will help them reduce the exposure to fossil fuel companies within their portfolio. As a result of this we are currently helping them transition their passive assets to ESG aligned funds with LGIM.

We have been encouraged by the pace of development in this space, in particular the availability of climate-aware index funds. However, we are keen to see this area continue to develop. We feel giving investors the option to invest in a manner that reflects scientific and policy language would be beneficial. For example, rather than leave it to schemes to assess what a carbon reduction through investment in a low-carbon index means for their temperature alignment, having funds that do this alignment for you will take a lot of the burden off schemes and give them greater visibility on the climate profile and alignment of their scheme.

In conclusion

Having set their ESG policies the thoughts of trustee groups will fall on how these are implemented for the long-term. We believe:

  • The broader range of pooled funds available in equities and credit that have an ESG focus is welcome.
  • The introduction of funds that track a climate related target should help trustees that want to, to more explicitly reflect their goals.
  • ESG indices and passive funds allow investors to express their ESG views in a cost effective manner

We leave you with the thought we started with. These are not altruistic decisions. Adopting a more ESG aligned policy has been seen to add value in the past and we can’t see any reason it will not continue to do so over the longer-term future too.

Want to know more about ESG?

Our new hub page provides advice on the regulatory ESG framework and client-focused solutions to help our clients with their ESG considerations. To learn more about ESG and how you can approach your investment meetings with confidence visit our hub page today. 

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