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Matching LDI and ESG

Matching LDI and ESG

28-12-2017 | Insight

Demand for sustainable Liability-Driven Investments (LDI) is outstripping supply. However, it is perfectly possible to integrate ESG criteria in all elements of a matching portfolio.

  • Remmert Koekkoek
    Remmert
    Koekkoek
    Head of Matching and Overlay Strategies
  • Yvo Schoemaker
    Yvo
    Schoemaker
    Portfolio Manager

Speed read

  • ESG can be integrated in matching portfolios as desired
  • We use components developed for fixed-income investments 
  • The cover and the potential return remain fully intact

More and more pension funds believe it is important for them to hold sustainable investments. Robeco also believes this. Not only for ideological reasons, but most of all because we are convinced that inclusion of relevant information relating to the environment, society and good corporate governance (known as Environmental, Social and Governance, or ESG) enables us to make better-informed investment decisions.

We are now able to integrate ESG criteria in all elements of the investment process in making matching portfolios sustainable. This is achieved by using the various components we have developed for our fixed-income investments. It is important that the quality of the cover and the potential return are not affected. This is a customized solution, in which the requirements and preferences of the pension fund are of primary importance.

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Integrating ESG in a matching portfolio

ESG investment analysis relates to long-term trends and changes, a perfect match with the investment horizon of a pension fund. When setting up a matching portfolio, we first of all determine, together with the pension fund, the allocation to the various asset classes based on our strategic outlook on the markets, the effectiveness of the cover, risk and return objectives and the target liability profile.

ESG considerations can then be integrated into all stages of the investment process: from top-down strategic asset allocation to bottom-up portfolio construction. This is illustrated using Figure 1.

Figure 1 | Integration of ESG in matching portfolios

Sourde: Robeco

The possibilities to offer added value using ESG vary per building block. This is illustrated by the number of green bars in Figure 1: the more green bars, the greater the potential added value. The pension fund's ultimate choice of investment universe thus influences to what degree ESG can be integrated into the portfolio.

In the first column, government bonds, the portfolio can be made more sustainable using the RobecoSAM Country Sustainability Ranking. This is a list of 65 countries, ranked using a wide range of ESG factors. We take a country's score and examine to what degree it deviates from the average score. Depending on the country universe in the matching portfolio, we then adjust the country weights accordingly. It is also possible to create a selection of countries based on ranking.

In the two following columns, government-related and credits, we can invest in ‘green bonds’. These bonds are issued by institutions and companies, and the proceeds are used to fund green projects. We only invest in green bonds if they offer an attractive return potential in relation to the creditworthiness of the issuer. We thoroughly screen the documentation of the bonds to establish whether the proceeds are genuinely used to fund green projects.

Furthermore, ESG can be integrated in the credit portfolio in various ways. RobecoSAM measures the greenhouse gas emissions, the energy and water consumption and waste production of the companies we invest in. We use this information to replace the bonds of companies with the greatest negative environmental impact by equally attractive bonds with lower impact.

Another way to introduce sustainability into a credit portfolio is engagement: entering into an active dialogue with selected issuers of corporate bonds with the aim of encouraging them to behave more sustainably. This active approach to promote corporate social responsibility fits well with the strategic views of many pension funds.

In the fourth pillar, the swaps, we work with high-quality counterparties and brokers who are also the most sustainable, assessing them according to sustainability scores. An ESG analysis also enables a better estimate of the long-term creditworthiness of bilateral counterparties.

In the fundamental analysis of all the components, ESG integration contributes to better-informed investment decisions.

Matching quality remains fully intact

The effectiveness of the cover, the return objectives and the target liability profile are the key priorities when setting up the matching portfolio. Making the portfolio more sustainable has no effect on these issues.

As an illustration, take the example of green bonds. How can these bonds improve the risk and return outlook of a matching portfolio? Figure 2 shows the yield curves of government bonds from France, the Netherlands and Germany and their relationship to the swap curve. The green blocks represent different green bonds in our universe. When selecting these bonds, we aim to have as many bonds in the upper-left section as possible. After all, the yield here is relatively high and the risk against the liabilities relatively low. The figure shows that there are enough green bonds available with a high matching quality. It is also clear that attractive yields can be obtained using green bonds. From a matching perspective, these are often even more effective than traditional government bonds from France, the Netherlands and Germany. They also offer diversification in a matching portfolio.

Figure 2 | Swap spread versus tracking error

Source: Robeco

We also see that there are large differences in terms of matching effectiveness and yield in the green bonds category. This once again underlines the need for solid credit and matching research and careful credit selection.

Disclaimer

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