ESG integration for passive portfolios

investment viewpoints

ESG integration for passive portfolios

In Conversation with Charles Morel

 

Sustainability is a matter of growing importance and it is an issue which is likely to shape markets for years to come. Consequently, it is a concept that we believe needs to be integrated in a holistic manner across the whole portfolio, including when it comes to passively-managed strategies.

In this Q&A, Head of Institutional Sales for Switzerland, Charles Morel, explains how we improve the sustainability of a passive portfolio through our low tracking-error approach.

 

Why is now right time to bring a low tracking error solution to the Swiss market?

One of the major drivers from our perspective has been the growing pressure put on pension providers to improve sustainability, particularly when it comes to reducing the carbon intensity of their portfolios and reduce extra-financial risks. A social consciousness more attuned to sustainability, which is increasingly reflected in the political agenda, is pushing providers to act on this front. With this pressure comes the growing awareness that inaction may force authorities to step in with new regulations.

The pressure to take action against climate change has been building for a while. In 2015, the United Nations Climate Change Conference, COP 21 was held in France. Switzerland signed up to this agreement, meaning the nation undertook a commitment to reduce carbon intensity. The financial flows are clearly in scope of the COP21 (Art.2). In connection with this commitment, the Swiss authorities introduced a survey directed at major asset managers as well as at the Swiss pension plans to measure the carbon impact of their portfolios, given their status as major investors or institutional investors in Switzerland.

This sense of urgency reached new heights last year when the Swiss Pension Fund Association (ASIP) defined sustainability as part of the fiduciary duty of the Swiss pension plans board members. They are now required to know what type of risk is held in the portfolio, whether it is financial or extra-financial or environmental. This focus on sustainability is growing and a lot of the associated risks are still given fairly low consideration by the industry.

Prior to this, there was few reasons, beside specific risk considerations, why pension providers would have needed to know what type of environmental and extra-financial risks may have been taken. The bulk of Swiss pension plans are largely invested through passive approaches in terms of core investments. Now that both the public and the regulator are putting emphasis on carbon intensity and extra-financial and environmental risks, there is heightened demand for compatible low tracking-error vehicles.

This is why we believed the time was right to come up with such a solution, and we believe we have a truly differentiated solution to offer.

 

How is sustainability incorporated into the Swiss Tracker+ ESG strategy?

There are three stages to this process. The first focuses on companies which needs to be excluded altogether. This accounts for a relatively small section of the benchmark as it exclusively deals with controversial weapons manufacturers. Securities of companies active in the controversial weapons sector incompatible with Swiss legislation or in contradiction with international treaties signed by Switzerland are excluded from the investment universe.

Once we have accounted for the exclusions, we identify those companies in the remaining universe which are involved in scandals or in controversial activities. Those companies are  underweighted, as are the securities of companies whose asset values are at risk due to changes in environmental regulations. The latter securities are referred to as ‘stranded assets’.  

The remaining companies are classified according to their ESG-CAR and their carbon intensity score. Our proprietary ESG (Environment, Social, Governance) /CAR (Consciousness, Action, Results) approach aims to differentiate companies simply claiming good intentions from those which demonstrate actual results from actions undertaken. The first dimension assesses the classic ESG score by evaluating the single components Environment, Social and Governance. The second dimension assesses our internal CAR components. When evaluating the mix of the ESG and CAR performance we put the most weight into the Result criterion, which also carries the most weight in the final sustainability score. The tilt used in the Swiss Tracker+ ESG strategy is the average of the ESG-CAR score and the Carbon intensity score. By doing so, we clearly put an emphasis on the environmental aspect (50% of the tilt on carbon intensity and the E component of the ESG score, representing a third of the weight).

The best scoring companies are overweighted and the worst underweighted. Our approach favours companies that deliver tangible results in terms of sustainability and avoid the greenwashing trap. The size of the over-under-weight is a function of the tracking error constrain of the strategy.

 

What kind of tracking error does this approach create?

Based on their ESG-CAR score, the securities of companies that are below the median are gradually underweighted, until they reach a maximum deviation of 0.15% for equities, and 0.30% for bonds. Securities from companies with a score higher than the median are overweighted to a maximum of 0.15% and 0.30%, for equities and bonds, respectively.  

Our back-testing shows a close correlation with the benchmark over the previous 10 year period. Our objective is a tracking error of max 50 basis points, ex-ante.

 

What effect does this management approach have on the portfolio?

This approach is highly effective in terms of risk reduction without substantially modifying the profile of the investment compared to the benchmark index. Through this process, we can significantly bring down the exposure to the most controversial companies in the benchmark while our focus on carbon has reduced the carbon intensity of the portfolio by more than a third. Finally, our exposure to stranded assets – securities which are at risk due to changes in environmental regulations – is also massively reduced.

To increase awareness and transparency, we have incorporated the relative exposure to the Sustainable Development Goals (SDGs) in the factsheets of the funds. The SDGs are becoming an increasingly well-known framework for corporates to address sustainability, so the proposed portfolio might improve the SDG score across all 17 goals.

In a nutshell, investors can significantly reduce their exposure to short-term and long-term extra-financial and environmental risks through this approach to index tracking without compromising the benchmark return and modifying its risk profile.

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