world in transition

How to improve the sustainability of a passive portfolio

How to improve the sustainability of a passive portfolio
Foort Hamelink - Head of Research

Foort Hamelink

Head of Research

Sustainability is recognised as an increasingly important issue for investors. Its relevance affects the whole of an asset owners’ portfolio, including passively managed strategies. In response to this, investors increasingly need to find cost efficient ways to implement low-tracking error portfolios that integrate sustainability and reflect their individual investment objectives and beliefs.

In this Q&A, Foort Hamelink, who is responsible for integrating ESG into bespoke portfolios at Lombard Odier Investment Managers (LOIM), discusses some of the key considerations investors face in assessing the most appropriate approach to improving the sustainability of a passive portfolio.


Why is it important to integrate sustainability into passive portfolios?

 Sustainability affects all regions, sectors, companies and asset classes so it’s increasingly important to integrate it in a holistic way across the whole portfolio. Doing so can meaningfully reduce exposure to non-financial and reputation risks and can help to mitigate the systemic – and therefore undiversifiable – risks associated with climate change. It can also help position a portfolio better for the transition to a more sustainable, low-carbon economy. However, it’s not just about risk. Transition on this scale can create huge opportunities as companies innovate to adapt and mitigate for climate change, for example. Our goal is to manage those risks and benefit from the opportunities.

That applies just as much to passive as active strategies, but, clearly, when it relates to passively managed assets, there are a few critical issues to consider. One is tracking error, which needs to be controlled. And the other is whether to integrate sustainability at the benchmark level, or in the portfolio construction.

Our goal is to manage the physical and transition risks associated with climate change, and benefit from the opportunities transition creates.

Should investors customise the benchmark, or the portfolio construction?

It depends. Large investors can more readily work with a fund manager or other party to create a custom benchmark. There are benefits to doing this, not least the implications for capital charges because a portfolio that passively tracks a custom benchmark should show negligible tracking error, and the benchmark can be perfectly tailored to meet the asset owners’ investment beliefs. We have seen a number of large pension funds moving in this direction.

But this isn’t suitable for everyone. The other option is to customise the portfolio construction and allow a degree of tracking error against a mainstream benchmark. There are a number of key advantages to this approach.

First, the benchmark is commonly recognised by all stakeholders, which helps establish a baseline that everyone understands and has a good degree of comfort with. Second, bespoke implementation allows investors to tailor the portfolio to fit their individual investment beliefs to hit specific carbon reduction targets, for example, or to track one or a group of Sustainable Development Goals. The tracking error can be controlled so it is proportionate to the clients’ conviction in their beliefs – if they want more carbon reduction, or a higher ESG score, that is perfectly possible, but it may mean a slightly higher tracking error.

Importantly, bespoke implementation also means the mandate is flexible and can adapt over time to reflect new information like developments in data or regulation, and also to reflect evolutions in the clients’ investment beliefs.

It’s also worth noting that the bespoke low-tracking-error portfolio I’ve just referred to can also be used to set the rules for a custom benchmark. This would provide strong transparency and can be easily verified by an independent third party.


Why not just track one of the index providers’ sustainable indexes?

This is one option, but, in our view, it doesn’t necessarily deliver an optimal outcome.

These benchmarks cannot be customised, for example, which leaves the investors subject to the ESG policy of the benchmark provider. This may not necessarily be the best reflection of the investors’ objectives, and they are also not very flexible to adapt over time. Passively tracking one of these benchmarks can also lead to uncontrolled tracking error versus the more widely recognised benchmarks, which most stakeholders are not familiar with.

The other route would be to implement a bespoke low-tracking-error portfolio against one of these ESG/SRI benchmarks, but that is fraught with conceptual problems. For one, there may be conflicts between the index provider’s ESG policy and that of the manager, which cannot always be easily resolved. Consider, for example, if the ESG/SRI benchmark already significantly allocates to a specific stock, which also has a good ESG rating by the manager: should this stock be overweighed versus the already concentrated ESG/SRI index? This could add significant stock-specific risk. Or, by contrast, the views on the ESG score of a company could differ meaningfully between the benchmark provider and the fund manager – how would that be dealt with in the portfolio? This approach can also create the potential for cost inefficiency as ESG/SRI benchmarks tend to be more expensive than mainstream benchmarks.

In our view, transparency is also really important and that is likely to be optimised when the client is involved in setting the rules for the ESG strategy.


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