Industry view – Society of Pension Professionals


existing index-tracking manager or platform.


Neil Davies is chair of the SPP Investment Committee


IS THERE MERIT IN SWITCHING YOUR INDEX- TRACKING FUNDS TO A MORE ESG-AWARE APPROACH?


This is a question which many trustee boards are asking at present, and relates to the fundamental question of, “what are you trying to achieve with your assets?” Is it: – A suitable return for the risk taken, or; – A suitable return for the risk taken and some societal benefit (subject to cost constraints)


These cost constraints come in the form of explicit costs, such as transaction fees and higher annual management charges, as well as the potential for implicit costs, such as tracking error.


The marketplace has seen an explosion of different ESG-related indices (there are estimated to be in the region of 1,000). However, when we step back and consider the investable indices for UK pension schemes the position is more manageable (i.e. an index may be replicated by multi- ple funds with different managers). The universe is often further restricted by gov- ernance constraints such as a bias towards accessing index-tracking funds from an


The use of the expression ‘index-tracking’ rather than ‘passive’ is deliberate. Passive investing is a type of index-tracking, where the index is based on a pure market cap approach, i.e. basing your allocations on the market size of each regional index and, within it, company size.


The importance of this distinction when discussing ESG, is that trustees are being implicitly asked to consider making an active decision on tracking an index that is not based on market cap. For example, based on historical data, and possibly con- trary to expectations, it is a decision that has had less financial significance than the decisions around the UK/overseas equity mix.


This suggests that, regardless of your answer to the above question, adopting an ESG-aware passive approach appears not to have been detrimental from a return perspective. But is there a stronger argu- ment in favour of moving? We set out some considerations below: – The direction of travel of regulatory and disclosure requirements, on a largely global basis, are pushing companies and trustees to take action to be aware of these risks – and by implication manage them;


– There will be periods when a more ESG/climate risk-related approach pro- duces lower returns than a passive approach – e.g. at a time of surging oil prices. This could be a reason against moving to an ESG approach now, when oil prices look historically low. However, be careful to distinguish between spec- ulating (short-term, market-level driven


decision making) and investment (long-term decision making). If you have a strong view on oil prices, for example, then this should be reflected in your portfolio. If not, it is no reason to


considering ESG. Instead, investors should think about longer term trends and how ESG risk may become more prominent.


avoid


– Having said the above, the final point to stress is there are no index-tracking investable solutions that are currently entirely fit for purpose – although some have made commitments that will see them evolve in future. Research carried out by Barnett Waddingham concluded that it is possible to achieve similar risk/return characteristics using ESG- tilted funds to the market cap approach (and so investors opting to remain in a market cap approach may not lose out in the short-term). However, the chang- ing nature of the underlying risks and the developments that may take place, mean this is an area requiring ongoing monitoring.


As always, the final decision appropriate for each scheme will depend on individual scheme circumstances, but with the grow- ing emphasis on ESG risk to investment performance, there are increasing argu- ments in favour of evolving the way that index-tracking portfolios are constructed.


Publisher portfolio Verlag Office 5.08 – 5th floor Fleet House 8 –12 New Bridge Street London EC4V 6AL +44 (0)20 7822 8522 london@portfolio-verlag.com


Editor Mark Dunne m.dunne@portfolio-institutional.co.uk


Deputy editor Mona Dohle


m.dohle@portfolio-institutional.co.uk


Publisher John Waterson


j.waterson@portfolio-institutional.co.uk


Head of sales Clarissa Huber


c.huber@portfolio-institutional.co.uk


Head of roundtables Mary Brocklebank m.brocklebank@portfolio-institutional.co.uk


Sales and marketing executive Silvia Silvestri


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12 | portfolio institutional November 2020 | issue 98


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