ESG Index Funds – From Decarbonisation to Customisation

    Stockholm (NordSIP) – A few weeks ago, we caught up with Frédéric Hoogveld, Head of Investment Specialists, Index and Smart Beta at Amundi during a short stay in Stockholm. Locally, Amundi is already well known for its cooperation with the state pension fund AP4 in devising a way to facilitate the implementation of low-carbon strategies. Together with Hoogveld, we revisited this journey into carbon neutralisation and found out how the firm’s sustainable investment strategy has developed since then.

    “Investors who want to address long-term issues and see their investments concretely contribute to sustainable solutions should turn to impact funds. However, if the initial mandate targets returns of the MSCI world, it will be hard move billions of dollars from there to solar panels, for example,” Hoogveld starts. “We developed a broad framework for low-carbon strategies for large index investors, such as AP4 or the French Fonds de réserve pour les retraites (FRR), to help them reduce their carbon exposure while keeping a relatively low tracking error relative to their capitalization weighted index.”

    The idea of creating indices with a low tracking error to their parent index with a smaller carbon footprint came as a significant innovation back in November 2014 when they were first launched. Since then these types of indices have seen a broad adoption, both by asset owners and asset managers worldwide. One of the reasons this trend has expanded is that beyond the environmental considerations of carbon investments lie the notion of risk. “On one hand you reduce carbon footprint, but you also de-risk the index, if you take the view that carbon-intense companies bear a future financial risk linked to their activity,” explains Hoogveld. “And the concept has also worked, as the relative performance of these indices has been positive since launch.”

    Hoogveld distinguishes three types of investor who have invested in low-carbon strategies. “The first category of investors is convinced about the fact that carbon-intense business will be negatively penalised as the world is evolving towards a 2-degree objective. The second category contains investors that have natural exposure to carbon, like some oil dependent sovereign wealth fund for example. Some of them have decided to exit fossil-related industries entirely, not only through indices, as they are looking to hedge their exposure to carbon risk.. The third investor typology includes those who, together with risk-adjusted return, have extra financial objectives such as sustainability embedded into their investment policy. Typically, charitable foundations or faith-based organisations, for example, have more demanding criteria than pure returns generation.”

    Demand for sustainable investment solutions from investors is increasing and becoming more sophisticated. “We see more and more demand for index customisation. Most index managers now offer ESG as well as low-carbon solutions, but what we offer as an asset manager is an open platform. Some clients are highly SRI-literate, while some others not at all. We must be able to adapt to a wide range of needs, as well as provide guidance and education when it is required.”

    Concretely, what an open platform in the context of index management can provide is a menu of different options to achieve the required level of sustainability. It can replicate multi-factor investment strategy, while for example subtracting a list of exclusions, integrating ESG factors or improving the overall social rating. However, a client might not always come with a predefined list of criteria. “The challenge is often to define the needs and show that there can be a trade-off,” says Hoogveld. “We start by educating clients on the broader topic of ESG. Then we go through the type of data we can use. There is a wide range of data providers, from thematic data to engagement, but also various degrees of granularity. Finally, we propose to replicate the index the client chooses while enhancing a particular aspect.”

    An example Hoogveld gives us is that of a client who chose to replicate the MSCI world, while reducing its carbon footprint, improving its ESG-rating using Amundi’s proprietary rating and increasing its exposure to the green sector at the same time. “I also believe that it is crucial to educate our clients about the trade-offs of filtering out companies or improving the ESG profile of the strategy. The more you reduce the carbon footprint, for example, the more the tracking error will increase. We can show the effects on the efficient frontiers, and how much the increase in sustainability will cost in terms of tracking error.”

    Picture © Amundi

    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA
    Aline Reichenberg Gustafsson, CFA is Editor-in-Chief for NordSIP and Managing Director for Big Green Tree Media. She has 18 years of experience in the asset management industry in Stockholm, London and Geneva, including as a long/short equity hedge fund portfolio manager, and buy-side analyst, but also as CFO and COO in several asset management firms. Aline holds an MBA from Harvard Business School and a License in Economic Sciences from the University of Geneva.

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