Article 10 November, 2021

Applying ESG factors to different asset classes

With most DB pensions de-risking and equities becoming a smaller component of assets, people are looking for ways to allocate to other asset classes.

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A question we are asked quite frequently is how we can apply Environmental, Social and Governance factors (“ESG”) to different asset classes.  This is not surprising as for a long time, the narrative around ESG has been mainly about equities.  The extent to which this is true is illustrated by Chart 1 below, which shows the universe of ESG funds split by asset class, with more than 50% of the funds invested in equities.  However, times are changing and with most Define Benefit (“DB”) pension schemes de-risking and equities becoming a smaller component of assets, people are looking for ways to allocate to other asset classes.   Below we outline a few options to consider and ask your Fiduciary Manager about.

Chart 1.  Equities dominate ESG funds

Source: Morningstar, April 2021, ESG Universe is defined by all fund names containing “ESG”, “Sustainable”, “Responsible”, “Ethical” and “SRI”

Liability Driven Investment – LDI.  Most schemes will already have an allocation to LDI, and it is possibly an increasing part of the portfolio. So, it’s definitely an area where investments’ ESG credentials should be considered.  In September 2021 the first tranche of green gilts was issued, in which we participated.  A further tranche was issued in October 2021 which we also took part in.

The issuance of green gilts is part of the UK Government’s aim to build out a green curve over the coming years.  This is to meet growing investor demand and to raise finance to fund projects that tackle climate change, finance much-needed infrastructure investment, and create jobs across the country. Ultimately, the idea behind green gilts is to use the finance they raise for green projects in line with the UK’s target of net zero carbon emissions by 2050.

Clearly the bonds are also ‘gilt-edged’ in terms of repayment reliability, so if you have the flexibility to allocate to them please talk to us soon to see whether they can be incorporated into the LDI portion of your portfolio.

Alternatives.  The use of ESG in alternatives is something that has been gaining a lot of traction in recent years.  Obviously, there are all sorts of alternative investments, particularly in private markets such as infrastructure, but one that we are seeing increased focus on is hedge funds.  Hedge funds theoretically sit really well with ESG, despite not being traditionally associated with the concept. The manager would simply be required to buy stocks they feel are value additive in terms of ESG credentials, while selling short investments they believe are value destructive.  It’s therefore a perfect combination to use to engineer returns from an ESG perspective and a concept that we have incorporated into our fiduciary management clients’ portfolios. This is an area where we expect to see more product innovation over the coming years.

Credit.  Many schemes will have exposure to cashflow matching or buy and maintain credit where the main goal is the reliability of the income that is coming in.  And the reliability of that income is predicated on those companies not defaulting.  Again, there is a strong link with ESG, as companies with stronger governance and who generally manage ESG risks well, are more likely to meet the debt repayments and less likely to default.

The challenge of course is that you typically get paid less well to hold higher ESG rated bonds.  In Chart 2 below, we show the universe of investment grade bonds split by ESG ratings.  You can see spreads for top quartile ESG companies are on average, about 25% lower than those with the poorer ratings and thus holders are paid significantly less well to own them.  It’s therefore important that alongside being able to demonstrate their process for managing value, your buy and maintain manager should also illustrate how they are limiting your exposure to those high ESG risk companies.

Chart 2.  A higher price to pay for ESG in credit

Source: MSCI ESG Research, Bloomberg as of 1 May 2021

Hopefully this has given some food for thought, and some areas to discuss with your Fiduciary Manager.  In particular, it’s a good idea to ask about specific examples or case studies where you can visualise how they might be approaching value additive ESG strategies.

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