There are multiple ways for tracker funds to help foster better financial and societal outcomes, says Meryam Omi, head of sustainability and responsible investment strategy at Legal & General Investment Management.
There are multiple ways for tracker funds to help foster better financial and societal outcomes, says Meryam Omi, head of sustainability and responsible investment strategy at Legal & General Investment Management.
There are multiple ways for tracker funds to help foster better financial and societal outcomes, says Meryam Omi, head of sustainability and responsible investment strategy at Legal & General Investment Management.
The face of traditional investing is changing. Stocks worth hundreds of billions of dollars are still traded daily but a growing number of investors are turning to index investing. Rather than attempting to beat the market by picking securities that are likely to outperform, index fund managers seek to track the market.
In equities, they own shares in every company that forms an index, such as the S&P 500. As such, index fund managers may be less concerned with the fate of any particular stock, but will probably care about the systemic issues that can affect entire markets such as climate change.
Diversification can help reduce risk, but only up to a point. Consider that out of every £1 paid in dividends by the largest 100 public UK companies, about 20p comes from just two large energy companies, our research suggests. More broadly, around a third of the world’s equity and bond markets are linked to carbon-intensive sectors, such as energy, utilities and mining1. As the pressures stemming from climate change intensify, how many of these companies will reinvent their business to survive – or even thrive – in the low-carbon economy?
Of course, none of us can predict the future, but this should not be an excuse for inaction. In fact, in a conventional globally diversified equity portfolio, investors could be unknowingly financing global warming of 4°C compared to the pre-industrial period – a world of “unprecedented heat waves, severe drought and major floods in many regions,” according to the World Bank. It goes without saying that portfolio returns are unlikely to be positive when even the road to the local cash machine might be under water.
Index fund managers are not powerless, though. We outline a few of the options available here: Tilting There is more than one way to construct an index. One useful option is ‘tilting,’ which starts from a broad universe of companies and then increases or reduces their index weight according to specific criteria, such as the management of climate change risks. For example, the alternative investment approach of one of Legal and General Investment Management’s (LGIM) funds has lowered exposure to the carbon emissions of its underlying companies equivalent to that produced by 20,000 cars (compared to traditional index investing). Without sacrificing diversification, profits and long-term purpose can be combined, in our view.
Engagement Index fund managers have to hold on to stocks for as long as they are part of an index. So they will want all the companies they invest in to do well. This raises the importance of engagement – using one’s shareholder rights to hold companies accountable and help shape their business models. We will meet company boards, have a direct dialogue and vote at shareholder meetings to send a consistent message to the companies in which we invest. During 2017, for example, LGIM supported 100% of shareholder resolutions calling for better disclosure on climate change.
Divestment/Reduction in holding weights Blanket divestment from companies and entire sectors can be a risky strategy, since it results in a more concentrated portfolio. Yet limited exclusion – and the threat of it – can still be a potent tool: research has shown that the targeted exclusion of certain stocks (e. g. companies with the worst ESG records) need not have significant impact on the tracking error of index funds, or the difference between their returns and those of the index they follow.2 At LGIM, we have designed index funds that exclude companies that consistently fail to meet sustainability standards, but with very little impact on overall performance.
These tools at our disposal are not mutually exclusive. In fact, we believe they are best used in combination. At LGIM, we offer index investors the opportunity for exposure to entire markets, while seeking to lower the chance of ‘nasty surprises’ in their holdings. In addition to helping lead to better financial outcomes, we believe this approach can also make a positive contribution towards societal goals.
