Now we have established environmental, social and governance factors are not a form of sustainable investing but instead a tool, we can turn our attention to the way they are used in standard workplace pension schemes.

In this post, I explained how examining ESG characteristics is a useful way for active managers to assess the risks of a particular company before deciding whether it should be included in a portfolio.

Tilted funds

This is not, however, how ESG is used in an auto-enrolled pension scheme. A significant proportion of your pension pot is invested in equities but uses passive rather than active strategies. Instead of selecting stocks, managers build portfolios which track indices such as MSCI World.

In order to make these benchmarks more sustainable, passive managers score the ESG characteristics of the stocks which make up the index and then ‘tilt’ the portfolio towards those with the highest scores. Those with the lowest ratings are excluded.

If we return to our spectrum of capital definition of sustainable investing, an ESG-tilted fund could be classified as responsible investing. In other words, the portfolio has been designed to avoid the most significant risks by ejecting companies with a terrible ESG record.

Fit for purpose?

But while these tilted indices have reduced ESG risk, concentration risk could become an issue.

With millions of members in DC schemes, the volume of assets in ESG-tilted passive funds grows all the time. If each fund rejects the badly scoring companies, the portfolio becomes more concentrated in a smaller number of stocks.

With every provider of an ESG-tilted index wanting to acquire the same companies, share prices of these stocks can climb creating a bubble. And bubbles have a tendency to burst.

Nor is it clear whether skewing a portfolio towards companies with the strongest ESG characteristics is the form of sustainable investing scheme members envision.

While the worst performing firms are not included in the portfolio, asset managers could be seen as doing little other than avoiding risk while not taking active steps to improve the planet and make society a better place.

Providers of ESG-tilted products can take steps to address these concerns by persuading companies in their portfolio to improve their sustainability.

If a company has environmental issues it needs to address, labour practices it needs to improve or a governance problem, the provider of the passive product can make use of its voting rights to persuade companies to improve these characteristics.

As I outlined in this post, asset managers can make a difference using these tactics. By working together, they persuaded oil and gas majors to adopt net zero targets. But effective engagement is a resource intensive business and will become even more demanding as companies turn net zero from a goal into a reality.

Activism required

Rather than relying on passive providers to become adept at persuading companies to improve their behaviour, there might be a better way for scheme members’ portfolios to protect the planet and improve society.

Active managers could select those firms with mediocre ESG characteristics and encourage positive change at these companies. With fewer stocks in the portfolio than a typical index, it would be easier to resource this type of engagement.

As well as using voting rights to change the behaviour of the equity portfolio, private credit managers can, for example, offer lower interest rates to those firms which improve their ESG characteristics.

At first glance, letting companies pay less for their debt seems counter-productive as the asset manager will make lower returns. But asset managers expect the value of the company to appreciate as their ESG profile improved, which will more than offset these lower incomes.

Returning once again to our spectrum of capital, this style can be described as impact investing as returns become as important as the improvements to planet and society.

Balancing act

This type of investment would help to counterbalance the concentration risk associated with an ESG-tilted index.

While benchmarks favour those companies with the highest ESG scores, an impact strategy would instead select those with mediocre ratings. In other words, these funds would diversify the portfolio and reduce concentration risk.

In addition, this investment style makes a compelling story for a scheme member. It’s much easier to persuade people their pension is looking after the planet and improving society if you have assigned that precise task those who manage the assets.

The next post will address why this type of strategy is not commonplace among auto-enrolled pension schemes.

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