Sustainable investing is following a well-trodden path. As a new investment trend gains popularity, it becomes more sophisticated as people get to grips with the concept. What started out as risk management has turned into making a positive change.
In my last post I explained how this journey leads us inexorably to impact investing and how these strategies often have an explicit link the UN’s SDG. So what does this mean for UK pension schemes?
The short answer is: it depends. The risk profiles, market forces and regulatory pressures are very different for auto-enrolled and DB pensions which translates into different strategies. This post will address the challenges facing introducing impact investment in auto-enrolled schemes while the next will address DB pensions.
DC and impact investing
Auto-enrolled DC pensions compete for market share on price. With limited budget available, the default investment choice is passive equities. As this article explains, many large schemes use ESG-tilted passive indices to make their portfolios more sustainable.
But as this post explains, there are questions about how sustainable you can make a DC portfolio using ESG-tilted passive indices. While a scheme can encourage the passive manager to improve the sustainability of the companies it owns, it could do more by adding impact investments.
These active strategies would not replace the schemes core passive equity holdings but would be a satellite investment – a complement to the core strategy. Larger managers would be able to find the cash for this more expensive approach by making the most of their economies of scale.
One way to add impact investing strategies would be to identify which sustainable development goals the scheme wanted to address.
For example, a scheme could decide to invest in a green energy fund. This would help to deliver the seventh UN SDG – provide affordable and clean energy. It was also act as an offset to the gas and oil majors held in the passive portion of the portfolio.
Those seem like compelling reasons. But green energy funds are very popular and, as a result, price of these assets is high. Impact investing may look to make positive change but pension schemes have a fiduciary duty to select assets to make long-term returns for scheme members. In other words, if the price is too high, this won’t be a good investment.
A better plan might be to look for less highly valued impact strategies. These might be linked to other SDGs or have less explicit links, such as a manager which selects those managers with mediocre characteristics which it aims to improve. The manager would need a proven track record of changing company behaviour for this to be a viable strategy.
While an auto-enrolled pension scheme might be looking for impact strategies which will produce positive change, the fundamentals of investing apply. As well as searching for those strategies which will make the most significant impact, valuations are important. Navigating these sometimes competing demands will be challenging.