ImpactAlpha, Oct. 1 – Most investments in public equities are held in “passive” accounts that keep fees low by tracking standardized indexes such as the S&P 500. Most companies included in such indexes aren’t cutting their carbon emissions fast enough to forestall the worst impacts of climate change.
So major institutional investors are moving to change the indexes.
The change could trigger a massive shift in assets and, over time, reward companies that make faster transitions to the low-carbon economy and punish those that move slower. In late August, passive funds that track broad U.S. equity indexes hit $4.27 trillion in assets, surpassing the amount of money invested in actively managed funds for the first time.
The world’s largest pension fund, the Government Pension Investment Fund of Japan, has moved $40 billion in its equities portfolio from a traditional passive index based on market capitalization to one weighted for environmental, social and governance themes and, in particular, de-carbonization.
On paper, GPIF’s biggest equity manager is BlackRock, the fund’s chief investment officer, Hiro Mizuno, likes to say. Because most of the GPIF’s assets are in passive accounts, indexes largely determine the fund’s holdings. Mizuno believes transforming index investing can be more effective than divestment in encouraging companies to transform their business models and disclose climate-related information.
The pension fund uses two climate-focused benchmarks—one for Japanese equities and the other for foreign equities. Both do away with traditional market cap metrics and instead weight companies in the portfolio based upon carbon efficiency and proactive disclosure of climate information.
“All the things we’re doing, we’re not really trying to make our portfolio look better, but trying to affect the whole market,” Mizuno told a rapt audience at last week’s Bloomberg Global Business Forum in New York. “The index has been a very convenient tool for us.”
David Solomon of Goldman Sachs, which manages the Japanese equity portfolio for GPIF, appeared with Mizuno at the Bloomberg forum. “It’s a creative way to make progress to move in a direction we all have to move in,” he agreed.
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More creativity is needed if we are to keep the planet from warming more than 2 degrees Celsius by 2050, an increasingly ambitious target.
Investors big and small have embraced index and exchange-traded funds that track a collection of equities as a convenient way to get broad market exposure and returns with cut-rate fees. But market-cap weighted indexes have a glaring flaw: they reward the largest companies by default, without regard to environmental, social and governance performance.
Index funds are typically weighted by market cap, meaning the bigger the company, the bigger portion of an index it represents, and the more shares are acquired. Such formulas effectively require investors to buy high, and sell low. Active managers have lately been warning of the prospect of a passive index bubble, including Michael Burry, the hedge fund manager famously profiled in The Big Short.
Moreover, the massive inflows to passive broad-market indexes threaten to accelerate, rather than mitigate, the effects of global warming.
“Investing in a simple index fund is immoral,” declares Trillium Asset Management’s Matt Patsky.
An explosion of niche indexes offer investors pre-packaged ways to track companies targeting renewable energy, vegan diets and electric vehicles. But niche products are at best supplements to investment strategies that offer exposure to the wider market that investors crave.
The most effective way to mainstream public market impact investing and send a powerful market signal may be to tweak the formulas that underlie popular market indexes.
Rather than attacking passive investing, a more constructive question might be, how do we nudge it in a more sustainable direction?
Moving to more sustainable indexes will mean overcoming challenges. Not least of which is pushback from traditional fund managers and hedge funds that actively pick stocks and stand to lose lucrative fees. Active funds, including hedge funds, rake in a combined $165 billion in fees annually, compared to $11 billion for index funds and ETFs, according to Bloomberg. Yet most have underperformed in the past decade’s bull market.
Then there is the power concentrated in the hands of three companies—Vanguard, Blackrock, and State Street—that together have captured 80% of the index fund market. That gives them enormous sway over the governance of companies and shareholder voting.
In addition, climate disclosure by companies needs to be more consistent and standardized.
Still, passive investing keeps gaining. The latest entrant into the broad market ESG game is Bloomberg’s SASB ESG Index Family. Launched in September, the funds apply ESG scoring (using State Street’s R-Factor) across broad equity indexes. “We are responding to requests from investors to offer comprehensive and competitive equity index solutions to help our existing index clients address their needs across asset classes,” said Steve Berkley, Global Head of Bloomberg Indices in announcing the new products.
In June, MSCI, a major provider of indexes, introduced the MSCI Climate Change Index, which weights securities based on the firm’s Low Carbon transition score. “We re-weight a very broad index” that can be tailored for the geographic or sector exposure clients need, and “at the same time tilted for ESG consideration,” explained Deborah Yang, managing director & global head of ESG Indexes at MSCI. As a company’s ESG performance improves, its weight increases, she added. The French utility EDF has adopted the index for a portion of its portfolio.
More big asset owners, especially in Europe and Asia, are rethinking traditional market cap-weighted approaches. In May, Ilmarinen, Finland’s largest pension insurance company, shifted $800 million from a traditional S&P 500 index to BlackRock’s new iShares ESG MSCI USA leaders ETF (the mouthful trades more simply as SUSL). That helped make it the largest ETF launch in history. SUSL assets have doubled since then, to $1.6 billion.
SUSL, which Ilmarinen helped to create, offers exposure to the top ESG performers within U.S. large- and mid-cap stocks drawn from the MSCI USA Index. It falls shy of a truly broad-based market index: in addition to selecting ESG leaders, it excludes tobacco, alcohol, gambling, weapons and other industries.
But the trend is clear. “I believe at some point ESG is just going to be ubiquitous. That’s the direction that we’re ultimately going,” Sarah Kjellberg, head of U.S. iShares sustainable ETFs, told ImpactAlpha.
BlackRock, she said, is often asked why ESG analysis isn’t incorporated into all its broad market indexes. “Until investors make that broad change, we still need to offer those [traditional] products,” said Kjellberg. “It will be up to these large asset owners who are willing to take that action and provide inspiration to others to follow.”