3 years of TargetNetZero Equity: a genuine transition approach

The TargetNetZero (TNZ) Equity strategies recently marked their three-year anniversary. Since they launched in late April 2021, we have sought opportunities beyond the obvious low-carbon sectors because we recognise that transitioning away from fossil fuels involves the entire economy. Our methodology pinpoints the companies that will have the largest and most effective impact on the shift, regardless of – and even because of – their current carbon footprints.

 

Need to know: Since launching in 2021, our TargetNetZero Equity strategies have sought out the leaders of the climate transition in every industry, unlike peers that avoid high-carbon sectors We do this using an in-house, forward-looking methodology developed by our sustainability research team Does investing in the transition bring value? We take a closer look at the performance of our strategies since inception

 

Focusing on high-carbon sectors

The objective of the TNZ Equity strategies (Global and European) is to deliver portfolios aligned with the goals of the Paris Agreement to hold global warming well below 2˚C. Our process leverages an in-house methodology developed by our sustainability research team: the Implied Temperature Rise (ITR). This is a forward-looking metric that identifies which companies in our investment universe have credible decarbonisation plans (for more detail on ITR, click here). 

Using this assessment, we seek to find leaders of the climate transition in every industry, unlike peers that avoid high-carbon sectors. TNZ portfolios have a greater focus on high-carbon industries, where we overweight ‘ice cubes’ (companies helping to ‘cool’ the economy) and underweight ‘burning logs’ (high-carbon laggards). This allows us to capture opportunities in sectors vital to the climate transition, as climate leaders will be ultimately rewarded with higher valuations relative to laggards.

 

Maintaining diversification

A number of unforeseen adverse events have occurred since the TNZ Equity strategies launched, including post-Covid inflation and the conflict in Ukraine. We have refined the risk model we use for portfolio construction along the way, and our investment approach and diversification have helped shield our strategies from the turbulence.

In 2022, much of our competitors’ underperformance stemmed from being underexposed to energy amid surging oil prices, while being overexposed to information technology and having a bias towards growth stocks in general. In 2023, higher interest rates worldwide and China's lagging recovery stymied global growth and challenged industries such as Renewable Energy. The relentless stellar performance of the ‘Magnificent Seven’ led many active funds to underperform.

With our approach, we aim to invest in net zero without taking undesirable risks, and we maintain tight limits on sector, country and stock deviations, leading to a low tracking error (below 1% p.a.). Figure 1 reflects our general alignment with the benchmark in terms of sector rotation – an important differentiator from many of our peers.

 

FIG 1. Sector allocation of TNZ Equity strategies  

Source: Bloomberg, LOIM, as of 30 April 2024. Benchmarks: MSCI World ND and MSCI Europe ND. Portfolio holdings are subject to change. For illustrative purposes only.

 

Our track record

1. Faster emission cuts

We expect our portfolios will decarbonise relatively quickly as a result of integrating estimated emissions in our stock allocation process¹. This is in contrast to Paris Aligned indices that pursue decarbonisation through rebalancing.

Nonetheless, despite employing advanced models, uncertainties persist. We have written before about the challenges involved in building climate-aligned portfolios given the uncertainties of forward-looking projections, as well as how we address them. Since 2023, we have integrated this consideration into our portfolio construction.

Figure 2 compares the decarbonisation of our two TNZ portfolios with their benchmarks over the past three years. This metric shows the change in portfolio emissions resulting from emissions changes at the constituents, rather than from rebalancing. Our portfolios have decarbonised faster than their benchmarks, and we expect this outperformance to expand in magnitude as the pace of emissions reductions accelerates².

 

FIG 2. Decarbonisation comparison (from TNZ Equity strategy inception through March 2024)

Source: LOIM estimates based on scopes 1, 2 and 3 as at 12.04.2024. Benchmark is the MSCI World index. For illustrative purposes only. Past performance is not a reliable indicator of future returns.

 

2. Opportunities are still ahead

In the race to meet the Paris Agreement emissions targets, governments worldwide are implementing policies aimed at decarbonisation. The momentum towards a net-zero future is clearly intensifying.

A key question is, does investing in the transition bring value? To address this, let’s take a closer look at the performance of our strategies since inception.

 

FIG 3. Performance of NetZero component since inception of TargetNetZero strategies

As of 1 May 2024. For illustrative purposes only. Past performance is not a guarantee of future returns.

 

The TargetNetZero ex-Energy style has been largely flat since inception in both strategies, meaning that markets have not yet started pricing in the future implications of the climate transition. As a result, the total returns of our strategies have lagged their benchmarks since inception: the TargetNetZero Global Equity strategy generated a net annualised 4.8% relative to the 5.6% of its benchmark and the TargetNetZero Europe Equity strategy returned 7.3% against 8.1%³.

With the market yet to price in the climate transition, we believe that the full potential of our strategies lies ahead.  

In a previous publication, we estimated that the full pricing of the impact on companies’ long-term growth would potentially result in double-digit outperformance for our portfolios. We must stress, however, that this is just one of many channels through which the climate transition will impact market valuations.  

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