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Pension fund chooses maximum sustainability and low tracking error

Pension fund chooses maximum sustainability and low tracking error

16-09-2019 | Insight
Quant meets sustainability. A Dutch pension fund was looking for an investment solution aimed at generating market-like returns, but also featuring very high sustainability standards and offering a relatively low tracking error relative the market capitalization-weighted index.
  • Jan de Koning
    Jan
    de Koning
    Portfolio Manager Core Quant Equities

Speed read

  • Client brief: a ‘passive-like’ strategy with a superior sustainability profile
  • ESG Indexing can combine sustainability with low tracking error risk
  • Strategy maximizes sustainability while avoiding negative factor exposures

We developed an innovative solution, which we label ‘ESG Indexing’, that only uses active risk budget to allocate towards environmental, social and governance aspects (ESG) instead of well-known factor premiums. In fact, this is Robeco’s first quantitative approach that solely uses a stock selection list driven by ESG scores to offer clients a passive portfolio that is active with regards to ESG positioning.

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The client’s needs

More specifically, this investor was looking for a strategy that would exclude from the investable universe the 25% worst-scoring stocks in terms of ESG and allow for the inclusion of other sustainable objectives, like lowering the carbon intensity of the portfolio. The client also wanted to exclude stocks of companies involved in the manufacture or distribution of tobacco products and controversial weapons. 

At the same time, they were aiming for returns similar to those achieved by a passive investment strategy, with a limited tracking error of only 1%. In addition, the client expected the strategy to remain flexible and allow for future additional sustainability customization.

Sponsored by a major Dutch financial institution, this pension fund considered itself a mainly passive investor, but it was also aware of the very high expectations among stakeholders concerning its ambitions in terms of sustainable investing. In other words, the trustees knew “all eyes were on them”. The fund was therefore willing to use any leeway available in terms of active share to tilt the portfolio towards more sustainable companies.

But while the client wanted to maximize potential enhancements in terms of sustainability, it was also reluctant to compromise on market returns. The risk with combining multiple sustainability objectives (e.g. a large exclusion list and ambitious targets for carbon intensity reduction and best-in-class investing) is that you end up with negative exposures to proven factors such as value, momentum, quality or low risk. These negative exposures may lead to underperformance relative to the market index, over long periods of time.

Robeco ESG Indexing

In this context, Robeco’s ESG Indexing strategy was soon found to be the best way forward. This innovative, rules-based investment approach lends itself particularly well to combining multiple sustainability goals while maintaining a low tracking error and delivering market-like returns.

The capitalization-weighted index is the starting point for ESG Indexing portfolios. Using an ESG-driven stock selection model and an innovative portfolio construction algorithm, slightly more weight is given to stocks with favorable sustainability characteristics and slightly less to unsustainable stocks.

When constructing the portfolio, the portfolio managers make sure that the target best-in-class score is achieved while the carbon footprint is reduced by 10%. Simultaneously, the algorithm keeps factor exposures in line with the benchmark.

Compared to most standard sustainability indices in the market, that only consider one dimension of sustainability integration, Robeco’s ESG Indexing optimizes the portfolio in order to achieve multiple goals simultaneously. 

This is done while preventing any negative factor exposures. Compared to more sophisticated custom ESG indices that can be replicated by a passive manager, Robeco’s Sustainable Enhanced Indexing offers a more significant ESG improvement per unit of tracking error.

Our approach allows for future customization if sustainability requirements or preferences change

Moreover, in contrast with standard sustainability indices, Robeco’s ESG Indexing allows for future customization if sustainability requirements or preferences change. Another important feature is the possibility to use investment flows to rebalance the portfolio in a smart way, instead of naively scaling up or down the portfolio, resulting in lower transaction costs. Finally, portfolio weights can be adjusted to actively integrate active ownership and engagement themes.

In terms of sustainability criteria, Robeco’s ESG Indexing approach offers several options for customization: exclusions, ESG integration and impact investing. Figure 1 illustrates these different options, that can be applied on various sorts of regional sectorial and even smart beta indices.

Figure 1: Flexible sustainability integration with Robeco ESG Indexing

Exclusions usually imply avoiding investments in controversial products or business practices, such as tobacco, weapons or thermal coal. 

Integration is about analyzing financially material information to be able to rank stocks, depending on the profile of companies, and favoring those with better ESG scores.

Impact investing enables investors to make a concrete socioeconomic impact in areas such as greenhouse gas emissions or waste generation. Impact investing even allows for the integration of the UN’s SDGs.

In this specific case, the solution chosen by the client uses a combination of those three approaches to sustainability integration:

  • exclusions: avoiding stocks of companies involved in the manufacture or distribution of tobacco products and controversial weapons
  • integration: avoiding companies with the poorest ESG scores
  • impact Investing: a 10% carbon intensity reduction relative to the benchmark
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