DIY strategies are ‘better and cheaper way’ to do ESG investing

A combination of digitising the value chain of the investment management industry, environmental, social and governance factors taking centre stage, and investors’ need to customise their index strategies has created the perfect storm for asset owners.

Daniel Leveau, SigTech’s head of investor solutions, said new exchange traded fund index products are being launched every week, but few are really 100 per cent aligned to investors’ ESG policies so they have to settle for off-the-shelf products.  

Care needs to be taken that using a bespoke index does not lead to unintended factor exposures, which in turn could create a risk and return profile that is not in line with the trustees’ overall goals

Eva Grace, Barnett Waddingham

“They would be better off tailoring index investments according to their desired risk factor exposure and incorporating their unique ESG policy,” he said. 

With custom equity portfolios, the asset owner can define the investable universe, tailor its index strategy to incorporate the ESG policy, by directly holding individual securities.  

While SigTech has historically helped asset management firms and hedge funds to produce their own custom equity portfolios, in the past few months the London-based company has started talking to institutional investors, including pension funds, about going down this alternative route. 

“Combining what we now know about ESG, what we know about indexing, and then with digitisation and the systems that we can use, we can offer clients the ability to customise equity portfolios in-house, without having to ask the index provider to customise one which can be costly [and usually requires a minimum investment],” it said. 

The largest pension funds are big enough to go out there and demand customised portfolios from their asset management firms, Leveau said.

“However, medium-sized funds that are quite large don't really have a big bargaining power when they talk to the asset management firms, and they have to settle for off-the-shelf products,” he said.

“Asset management firms tell them they’re too small to be able to do something like that. Instead of just buying an off-the-shelf product from an asset manager, they can create it themselves.”

Benefits of a custom equity strategy

One of the potential problems with ESG investing in an off-the-shelf index is that it might be optimal for one client but not for another client.  

“For example, a pension fund that is underfunded cannot take on the full market risk. Also, there is no universal standard of ESG, it means something different to everybody and there are different ways to implement the same ESG policy,” Leveau said. 

A custom equity strategy can allow investors to exclude certain sectors and then take a more active approach to skew the portfolio towards anti-climate change companies, or have a carbon neutral portfolio.  

“In order to really be an active owner, which is also becoming more and more important, you need to own the stocks,” he continued.

“If you own the ETF or the index fund, you have nothing to say about that, you cannot take your ETF shares and go vote. A pooled investment vehicle only gives the investor indirect ownership of a security. This makes it more difficult for an investor to become an active owner.” 

By owning the securities directly, the investor can actively decide to what degree it wants to be an active owner through voting and engagement.  

This method can also help investors gain optimal exposure to various risk factors. For example, one investor might want a global equity exposure with larger downside risk, while another might want a larger bias to small caps.

Leveau said investors can use custom equity portfolios to be better prepared for a potential downturn in the equity market; for example, they could create an equity strategy that has lower downside risk. 

“The traditional market cap-weighted index has really worked in this longest ever bull market, which is skewed to mega caps and growth,” he explained.

“I have a feeling that investors have become a bit complacent in terms of what works and what does not work. Looking at how equity markets have performed in the long term, it is rarely the case that something continues to be the winner in this decade, the next decade and the third decade.” 

Custom equity portfolios or direct indexing could also help pension funds reduce their costs, according to Leveau.  

“If we take the example of a pension fund looking to invest between £250m and £500m in an index equity product with a comprehensive ESG policy, estimated management fees would be between 5 [basis ponts] and 10bp, resulting in fees up to £250,000,” he said. 

Depending on the investor’s in-house skill sets, creating and implementing a fully customised equity portfolio would cost less than £100,000 a year. In this example, the pension fund would more than halve its management fee.”

‘Care needs to be taken’ with bespoke indices

Eva Grace, associate and senior investment consultant at Barnett Waddingham, told Pensions Expert that while tailoring a bespoke index “has the benefit of reflecting a pension scheme’s idiosyncratic ESG views, we find that many trustee boards share broadly similar views, and therefore an off-the-shelf solution can often fit the bill”.

Should a bespoke index be required “in order to reflect a trustee board’s view”, there are considerations they will have to account for, she continued.

“These considerations impact the construction of the index itself and the need to engage and vote in a manner consistent with the underlying principles. The introduction of implementation statements means these efforts have to be reported on publicly.”

She added: “Care needs to be taken that using a bespoke index does not lead to unintended factor exposures, which in turn could create a risk and return profile that is not in line with the trustees’ overall goals.”

In addition, there are certain benefits to the bespoke index approach, “which traditionally only large schemes have been able to take advantage of”, Grace said.

“For example, a benefit of directly holding stocks is that it gives the investor with the appropriate resources at hand the opportunity to take ownership of voting.”

However, she cautioned that with the number of votes of an equity portfolio reaching into the thousands in a year, “this may not be something that trustees of medium-sized pension schemes have the scope or governance to be able to do”.