Deviations from standard equity benchmarks are inevitable when ESG factors are included in index methodologies, argue investment experts.
Tracking error is expected to rise further for investors as they increasingly set net-zero goals and some focus more on impact strategies.
This may create challenges for low-carbon indices, which aim to minimise tracking error, potentially necessitating a rethink of investment strategies.
Investors seeking to reduce the carbon intensity of their asset portfolio often benchmark against low-carbon indices. Some large and respected asset owners have been doing so for years.
New York State Common Retirement Fund has used a low-emission index for its passive equity investments since 2015. Swedish national pension fund AP4 started benchmarking its entire global equity portfolio against low-carbon indices in 2014. And California State Teachers’ Retirement System takes a similar approach, incorporating developed-market low-carbon benchmarks from MSCI.
The more a portfolio tilts to low-carbon stocks, the more it deviates from typical market benchmarks, often resulting in a larger tracking error. Low-carbon or low-emission indices are designed to minimise that risk.
But some investment experts believe a rethink is now needed: investors should attribute less importance to tracking error if they really want to achieve net-zero portfolio emissions.
For a portfolio to be truly Paris Agreement-aligned or decarbonised and have minimal tracking error is impossible, as it would “inevitably be running triple-digit tracking error”, says Carlo Funk, head of ESG investment strategy for Europe, the Middle East and Africa at State Street Global Advisors (SSGA).
“If we truly as a financial community want to achieve net zero, as laid out by various pathways and scientific reports, we need to change our thinking on how we approach things on so many levels,” says Funk.
He wrote a paper on the topic in March, which showed among other things that even significant tracking error does not affect overall index performance (see chart below, which is also dated to March).
Yet climate change is so disruptive, he argues, that it affects how investors think about valuations and about risk. “And it should have an impact on how we think about conventional benchmarks.”
Funk’s view is shared by Mona Naqvi, global head of ESG capital markets strategy at S&P Global Sustainable1, the sustainability data arm of rating agency S&P Global. Investors pursuing net-zero strategies could see their portfolios experience “exponential levels of tracking error and active share unless the global economy decarbonises alongside it”, she said at a virtual forum this month hosted by Capital Monitor and the New Statesman.
“Paradigm shift” needed
Hence a “paradigm shift” is needed if investors are to transition to a net-zero economy, said Naqvi on a panel during the event, entitled Making Sense of Net Zero.
ESG versions of indices are often “light touch” in terms of their sustainability focus, in order to remain close to their reference benchmark and reduce tracking error, she added.
But that approach could start to change in light of the EU’s recently introduced Sustainable Finance Disclosure Regulation (SFDR). The rules require ‘double materiality’ disclosure, whereby fund managers must report on both material sustainability risks to their invested assets and the impact their portfolios have on people and the planet.
A very small subset of clients are starting to take the view that tracking error is no longer important. Carlo Funk, State Street Global Advisors
At least partly as a result, S&P Global’s clients are focusing more on risk, return and impact, to align with EU regulation and net-zero goals, Naqvi said. “So rather than hugging the benchmark and keeping that tracking error tight… we are by design trying to achieve a future point in time, net-zero-aligned, that looks very different than the world looks today.”
Integration of ESG – and climate factors in particular – into portfolios will inevitably lead to deviations from policy benchmarks, Funk agrees. “And that is starting to become a very big discussion point for investors.”
Clients using SSGA’s low-carbon products give the fund house either a tracking error budget or a carbon-reduction target with as low a tracking error as possible, he adds, and it seeks to optimise this.
Tracking error losing importance?
But “a very small subset” of clients are starting to take the view that tracking error is no longer important, Funk says. They are often investors seeking impact, and their chief approach is to engage with companies.
Craig Mackenzie, head of strategic asset allocation at Aberdeen Standard Investments, agrees that investors need to stop “obsessing” over tracking error, which has a one-year time horizon, and think more about long-term risk.
“How would an institutional pension fund deal with a scenario where over ten years the low-carbon index underperforms the standard benchmark by 2% to 3%?” he tells Capital Monitor.
Unlike Funk and Naqvi, however, Mackenzie argues that “it’s pretty easy to build net-zero portfolios without much tracking error”. Aberdeen Standard has done so, he adds, producing “say, 50% less carbon intensity than the standard benchmark with a tracking error of 20 basis points, which is pretty small for equities”.
In fact, successful engagement with companies will allow progress in portfolios towards net zero with no additional tracking error at all, argues a December study by Aberdeen Standard and British life insurer the Phoenix Group.
Whether or not investors are happy to accept a fund that fails to track a benchmark perfectly, it is yet another aspect they must consider if they have ambitions to achieve net-zero portfolio emissions.
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