ESG Passive Equity

Client-Specific Concerns

The pension fund’s investment team, which began working with bfinance in the midst of reorganizing and consolidating its equity allocations, had recently refined its strategic investment policy to reflect its ESG priorities. The team was seeking to increase the fund’s credibility as an ESG-aware pension manager and wanted to ensure that its new passive allocation would replicate its chosen ESG equity indices. The team also had several specific ESG screening requirements that it needed prospective managers to accommodate, such as excluding investments in tobacco companies and cluster munitions manufacturers.

The investment team was seeking a passive exposure through pooled funds, so the structure and tax efficiency of the vehicle was particularly important to mitigate any potential performance drag versus the indices. The client considered the efficiency of implementation (specifically low tracking error) and overall vehicle costs and fees to be critical to the selection of a prospective manager (or managers) in the context of a shift to a fully passive approach.

Outcome

• Assessing the available investment options in granular detail Although this manager search was for a passive allocation, it was handled with as much depth and breadth of research as an active-management mandate. We conducted a detailed review of the construction of passive ESG indices and looked at the relevant managers’ portfolios that sought to replicate them, since the implementation of many ESG equity indices can be heterogenous (even if derived from the same ESG index ‘parent’).
• Evaluating the comparative benefits of ESG indices.We assessed the design of various ESG indices, including whether the manager used only backward-looking ESG data or also incorporated trend data; if weightings were adjusted based on ESG scores; whether the manager used any proprietary ESG analytics or in-house scoring; and how strict the managers’ exclusion thresholds were.
• Delving into the application of ESG engagement tools. At the company level, the ESG review was more comprehensive than usual given the client’s focus – we looked at portfolio managers’ team resourcing, engagement and voting practices, and the extent to which managers were adept at identifying companies that were ESG leaders (or laggards) in their respective industries. Understanding engagement is particularly challenging in a passive context, we were intent on identifying managers that took engagement seriously for their passive clients.
• Exploring managers’ approaches to partnering with clients.We sought to assist this client in differentiating managers that could partner with its investment team over the long term, which was a bigger ask of managers for a passive pooled fund mandate than it might have been for an active, segregated account. However, we wanted to make sure that the shortlisted managers were prepared to work with the client as its own ESG needs evolved over time.
• Focusing on cost structures to enhance returns.We also placed particular emphasis on the cost structures of different pooled products under consideration, highlighting how different managers could enhance index returns – or at least claw back costs – by implementing various trading efficiencies.