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June 15, 2021updated 21 Feb 2022 10:45am

The risk and rewards hidden within the new generation of ESG funds

The development of new ways to apply sustainable capital is truly exciting, but investors must pay close attention to how new fund offerings are created and the ESG data on which they are predicated.

By Daniel Flatt

The green data underpinning new ESG funds is crucial to the future success of impact investing. (Photo by Vadym Pasichnyk via Shutterstock)

  • Finnish pension scheme Varma has committed $275m to State Street’s new green bond fund.
  • Engine No. 1 is proposing a unique proxy voting play in the ETF space.
  • Investors need to pay close attention to the ESG data underpinning the new investment approaches.

The means by which investors can use capital to influence corporate activity has increased dramatically. Many new funds proposing to make a difference are little more than standard investment strategies dressed up with ESG labels. However, there are positive signs that managers are now providing more tailored approaches to tracking impact.

A fresh example comes from State Street Global Advisors (SSGA), a Boston-based $3.59trn asset manager, which announced the launch of a series of tailored green bond funds on 14 June.

The funds are benchmarked against the Bloomberg Barclays US, Euro, and Global Corporate Bond indices, with all three funds applying  “screens and tilts” designed to target securities tied to issuers that are mitigating and adapting for climate impact. A key component of SSGA’s strategy is to hoover up self-labelled green bonds. The manager believes this will provide the assurance that capital raised will be directly allocated to lower carbon-intensive projects.

Active exclusion

According to Rupert Cadbury, an ESG fixed income strategist at SSGA, the bonds are screened subject to criteria in the Climate Bonds Initiative (CBI) Green Bond Database Methodology and filtered to include only bonds with 100% use of net proceeds financing or refinancing environmental projects. Social bonds are excluded. Bonds must also be “broadly” aligned with the CBI Climate Bonds Taxonomy, effectively excluding bonds financing clean coal, for example.

Cadbury tells Capital Monitor: “Climate-aligned issuers and outstanding unlabelled climate-aligned bonds: upon screening the issuers’ business in a similar manner to green bonds against the Climate Bonds Taxonomy, issuers are included if at least 75% of their revenues derive from aligned business lines, and they have outstanding debt.”

A cornerstone investor to the funds is the €50.2bn Finnish Varma Mutual Pension Insurance Company, which has allocated $275m. The firm has publicly committed to having a carbon-neutral portfolio by 2035. Inside that target, Varma said in its 2020 sustainability report it wishes to reduce emissions from listed corporate bonds and equities by 50% by 2027 compared to its 2016 portfolio exposure. The fund has around 23% of its portfolio invested in fixed income instruments as of 2020.

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Given that green bonds are self-labelled, the ability for Varma to measure the impact of its investments and benchmark it against its stated commitments is dependent on the methodology applied by managers such as SSGA and, in turn, the criteria of third parties such as the CBI to quality check the ESG data of issuers of green bonds versus their own specific KPIs. Screening out bond deals that lack impact and transparency is paramount.

Who monitors the monitors?

Also crucial, therefore, are the second-party opinion makers that provide additional information on the bonds themselves and the frameworks upon which they are based. A quick analysis of the International Capital Market Association’s (ICMA) green bond database shows that out of 641 green bonds tracked, 61% are covered by Cicero, Vigeo Eiris and Sustainalytics, with the latter dominating market share (35%). Investors would be wise to learn the business models of all these opinion providers.

A similar dependency arises in the equity markets. Capital Monitor has previously commented on the risks of greenwashing bubbling up within the fund management sector. The proliferation of ESG indices and the funds launched are proving very popular, but the ESG ratings underpinning them are under intense scrutiny. Questions are being asked as to whether investors really understand the methodologies of the agencies applying ESG scores to the company names that form the indices being created.

One investor that appears to be taking a slightly different tack is Engine No. 1. Brought to fame very recently for its success in convincing some heavyweight investors, including State Street, to support its bid to plant new members onto the Exxon Mobil board, the US-based firm is now priming the launch of an exchange-traded fund, Engine No. 1 Transform 500 ETF, to raise more capital.

According to a 28 May filing with the US Securities Exchange Commission (SEC), the ETF would aim to “encourage transformational change at the public companies within its portfolio through the application of proxy voting guidelines”.

Passive targeting

A traditional passive ESG ETF would apply a responsible investing philosophy and exclude names on the basis of their ESG scores or sector they sit in. By contrast, Engine No. 1 will target companies in the consumer, energy, financial services, healthcare, technologies and utilities sectors within the Morningstar US Large Cap Select Index and work to make them better corporate citizens via the voting booth.

Importantly, Engine No. 1 will measure the impact of its investments based on information provided by the companies themselves, third-party data providers, and its own proprietary research. The SEC filing states the investor “will generally follow the recommendations of an independent third-party proxy voting service”. It seems likely the third party will be ISS, although a spokesperson for Engine No. 1 declined to make any comment on the story due the filing status of the proposed fund.

In the same vein as SSGA’s new green bond funds, the source of ESG data and the reliance on third-party providers to deliver relevant ESG insights is crucial. Again, investors keen to ensure their money is making a real difference should make time to understand how such fund managers acquire and act on information.

Either way, the development of new investment strategies and ways to tackle the world’s most pressing problems is exciting. And it's not just happening within the mutual fund markets space. Hedge funds are in on the act and applying their own philosophies and ESG data to drive change and make a return on capital.

The long and short of it

Take Hite Hedge Asset Management’s Carbon Offset fund, for example. It’s play is to short fossil fuel companies and long the rest of the stock market.

“It is a way to [capture] the relative underperformance of fossil energy,” says James Jampel, founder and co-chief investment officer at the Massachusetts-based firm. “So, we would make money if the market went up more than fossil energy, or if fossil energy went down more than the market.”

Hite launched the fund, which now accounts for $180m of the firm’s $620m under management, in 2017. Jampel says he and his co-CIO Matt Niblack had concluded that the fossil energy business would be “extremely challenged”, as “the world was going to decarbonise”. And they felt the carbon offset strategy would be a way to profit from that.

Given its modest overall size, unsurprisingly Hite does not have a big roster of large institutional clients. But it does count a US university endowment among the investors in both its energy-neutral and its offset fund, as well as several family offices and high net worth individuals, says Jampel.

And in order for such managers to convince more institutional money to come their way, they will need more confidence their strategies are truly having an impact. Funds such as Finland's Varma are betting their entire credibility that managers such as SSGA can demonstrate they are reducing exposure to carbon-intensive activities. Let's hope they are proven right.

Additional reporting by Joe Marsh

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