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Meryam Omi and Nancy Kilpatrick on LGIM’s Future World Fund
and why addressing climate change is in the
interest of long-term
LGIM’s Meryam Omi and Nancy Kilpatrick present the Future World Fund which uses an alternatively weighted multi-factor approach to target enhanced risk-adjusted returns over a traditional market cap weighted index strategy.
The fund also incorporates a climate ‘tilt’ to address the investment risks associated with climate change. The managers also aim to capture our global energy transition by looking at three data points: carbon reserves, carbon emissions and green revenue. Further, LGIM incorporate an engagement overlay which provides compelling value beyond a traditional index fund.
Impact investing: capturing value through a climate tilt and an engagement overlay
LGIM’s company engagement
Market appetite for green investments, such as renewable energy and low-carbon industries, is strongest in Europe, according to a recent survey by East & Partners. The market research firm found that fund managers are increasingly focused on opportunities as well as threats related to action against global warming. Indeed, 97% of respondents plan to increase capital allocations in low-carbon technology or other assets that stand to benefit from climate policies.
Legal and General Investment Management (LGIM) is one fund manager already meeting clients’ goals with this thematic: “We take our responsibility to act as good stewards and influence change seriously, devoting significant resources to this effort,” says Meryam Omi, Head of Sustainability and Responsible Investing Strategy. “Investors are increasingly realising the need to address the long-term financial risks and opportunities associated with climate change and the shift away from traditional energy models.”
In addition to its alternatively weighted factor based tilts, the benchmark index which the Future World Fund tracks answers this investor need by incorporating a climate ‘tilt’ to address the investment risks associated with climate change. The tilt allows the fund managers to reduce exposure to companies with worse than average carbon emissions and fossil fuel assets, while maintaining their broad sector exposures. In doing this, the strategy produces a similar equity return compared with a traditional index strategy but with impact; without the need to compromise on diversification.
Omi explains: “The climate tilt within the index has three elements which are quite distinctive. The first is that we capture the energy transition. By this we reduce the exposure to the overall carbon risks, and increase the exposure to the green economy.
“The second element is that we engage with companies in a way that has a real consequence. We say to the companies: ‘This is the transition that is happening, we want you to be a part of it, and we want you to be successful. But if not, there is an investment decision to be made.’
“And the third element is that we engage with the end-investors and tell them how their money or helping to finance the world and the future we will have. And what we are doing to enhance their returns and to the society at large.”
Over time, the group’s intention is to improve the standards and practices of the companies in their portfolio to make them more resilient to policy changes, more successful in providing low-carbon solutions and, ultimately, more prosperous. It then follows that in the long term, LGIM clients who hold stakes in these companies should benefit from their financial success.
Omi says: “We hope to dispel the misconception that ESG-focused strategies must compromise long-term returns in order to achieve their broader goals. As investors continue to re-evaluate the suitability of their investments in the context of their broader values and beliefs, LGIM is determined to play a key role in helping our clients invest for the future in which they want to live.”
Omi and her team have identified six key sectors – oil and gas, mining, utilities, automobiles, financials (banks and insurance) and food retail/producers. The largest companies in these sectors are ranked based on a scoring methodology incorporating criteria such as transparency, innovation, public policy, board governance and reputation.
The companies with the lowest rank become candidates for exclusion from the Fund at the next semi-annual review date, following an engagement period (initially 12 months). The threat of exclusion during this period will be used by the Corporate Governance Team to drive better company behaviour. LGIM will also publish on a semi-annual basis the list of companies that have been excluded.
“For the first time, we have gone beyond just engagement and voting, and allowed a small capacity to divest from companies to hold them to account on climate issues,” says Omi.
Climate impact pledge
One component the manager is “very proud” of is the group’s climate impact pledge, which follows in the footsteps of the Paris Climate Accord. Signed by 195 countries in November 2016, the accord is the world’s first legally binding commitment to limit global warming to 2°C above pre-industrial levels, with a stretch target of 1.5°C.
LGIM’s own pledge is to target companies in the sectors they believe will have the most impact on the transition to a low-carbon economy, to ensure their engagement has real consequences.
companies – led to direct engagement
companies contacted and informed of our methodology, to make improvements on climate strategy
Mid next year – those who fail to meet our minimum standard may be
We have gone beyond just
engaging with companies and now have a vehicle to hold them to account on climate issues
A ‘climate tilt’ is used to identify companies that are positioned to perform well in a low-carbon environment.
The fund reduces exposure to companies with worse than average carbon emissions and fossil fuel assets.
The fund increases exposure to companies that are generating revenue from the green transition.
In order to fulfil the climate pledge, the Future World Fund has a tracking error budget to fulfil the pledge.
About the Future World Fund's Climate Pledge
Balanced Factor Index
Climate Balanced Factor Index
Climate measures versus Market Cap (as at 20/03/17)
Tracking Error between Balanced factor Index & Climate Balanced Factor Index: 46bps
Source: FTSE. Modelled performance from September 2001 to March 2017. Please note prior to 07/11/2016 the climate balanced factor index had not yet been launched so performance is backtested, and there after this date performance is live. Simulated past performance is not a guide to the future
We have run funds against alternatively weighted indices for over a decade
We use our powerful market leverage to encourage companies to make the low carbon transition
We share the stories of our successes with pension scheme members
We’ve worked with FTSE Russell to create a new index that includes weighting each stock with a carbon and green factor
We invest in the companies positioned to perform well in the move to low carbon
Used this expertise to develop our factor-based capability, giving our index investors the potential for better performance but keeping costs low
LGIM: our Future World Fund retains the benefits of a balanced factor approach while reflecting climate risks
LGIM: our Future World Fund is a long-term investment that helps manage climate risk and build a better future
A strategy to address client concerns
Stock is removed (or reinstated) at the next semi-annual index review date (March and September)
The Future World Fund
Stocks are removed in the order of their scoring (lowest score first), up to a maximum tracking error budget of 0.30% p.a.
Failure to change
Add to Divestment list
Stay in the fund
LGIM analysis of c.90 companies
Changes made, score increases
Remaining stocks rebalanced with an objective to remain sector and country neutral
Future World Fund: Divestment within an acceptable level of tracking error
Improving company engagement
LGIM: academic research shows that tilting the traditional index with these core factors can add value over the long term, but it is difficult to time these factors over the short term
Using factor-based investing to add value over the long term
The Future World Fund aims to provide better risk-adjusted returns over the long-term by using an alternatively-weighted index that tilts a conventional market-capitalisation index in order to gain exposure to four factors. Academic research* has shown that these four factors can add value over the long-term.
*The rise of factor-based investing article available on LGIM’s website: www.lgim.com/uk/en/insights
The Future World Fund retains the transparency and cost effectiveness of a conventional index fund, but also provides the opportunity to enhance investment returns by incorporating these factor tilts. Please note that the factor mix may change over time. We ensure that the factors are relevant to the longer-term time horizon of investors in the Fund.
Small capitalisation stocks (small caps) that have outperformed large capitalisation stocks
Stocks with strong, sustainable returns characterised by high profitability and low leverage
Stocks with lower volatility that have outperformed the market on a risk-adjusted basis
Stocks that are “cheap”, i.e. that trade at a discount to fair value using their fundamental metrics
The ‘Climate Balanced Factor’ Index
We can deliver global equity style
returns but also have quite a large impact on carbon reduction within the portfolio
When did you launch the Future World Fund and what is it designed to do?
In 2016, together with a major UK pension scheme, we launched the Future World Fund in order to help investors address the long-term financial risk of climate change, turning our existing approach into a real-world solution for our clients.
In addition to its alternatively weighted factor-based tilts, the fund is an index-based strategy which incorporates a climate ‘tilt’, giving investors greater exposure to companies that generate green revenues and that are more likely to benefit from the transition to a low-carbon economy. The tilt reduces exposure to companies with worse than average carbon emissions and fossil fuel assets, whilst maintaining broad sector exposures. It also rewards companies of the future, by tilting towards companies that generate greater green revenues – investing more in the companies that would benefit from the energy transition.
Why should fund buyers invest in the strategy?
The beauty of this particular strategy is that it’s very much, as I mentioned before, a mainstream strategy.
The value for fund buyers is getting that ‘known return’ from a global equity-type mandate – but on the other hand, you also get a great amount of impact. In terms of carbon reserves, as at March 2017, you could get a reduction of up to 90%, with emissions at 50%. But what’s really key is the transition to the future. And as at March 2017 again, the levels in terms of green revenues were enhanced by 80%. Investing in those future technologies will help us to transition successfully in the future we want.”
So, with that in mind, I guess my question comes back to you in a way: why wouldn’t fund selectors consider this as a core part of their portfolio?
What are the emerging trends in the market today?
I think there has been an undoubted shift towards passive or index-tracking investment versus, say, active. This is because more of our clients and investors are looking for cost-effective solutions to meet their needs. More recently, we’ve seen a move towards solutions-oriented portfolio construction and the broader trend in the market is about being smarter in how we as investment professionals target outcomes for our clients. We see examples of this with the arrival of value indices and smart beta-type, in other words, ‘factor-based’ strategies.
Why is climate change a financial issue?
It’s really about the ongoing energy transition. For us, it’s the energy and risks associated with climate change but also evaluating the opportunities. Every day we’re seeing the emergence of new technology that is helping the energy transition: electric cars and cleverer ways of storing energy, for example. We think that parts of the fossil fuel industry will be outdated in the future; and if we can encourage and invest in companies which are helping the transition to a lower-carbon economy, we see that as a financial benefit for our clients.
What is the investment philosophy behind the climate tilt in the index strategy?
The climate tilt within the index really tries to capture the energy transition by looking at three data points. The first one is carbon reserves. That’s fossil fuel reserves that companies own and they might not see as having a bright future if we’re actually going to transition to a low-carbon economy. So we try to have less exposure to companies that are over-exposed.
The second one is carbon emissions. These are the companies that are emitting carbon, and again we look at one company over another in the same sector. The index tries to reduce exposure to the ones that are much more intensive than their peers.
And the third component is green revenue. It’s the companies’ revenues that are coming from the low-carbon transition: renewables, efficiency, smart grids and so forth. So again, we try to increase exposure to the ones that actually have that opportunity side captured.
The key to our investment strategy is that, with it being a mainstream portfolio, we can deliver global equity style returns but also have quite a large impact on carbon reduction within the portfolio. The combination of carbon, green and the impactful engagement is something that doesn’t exist in the market.
But I think the real impact piece is the ability of our corporate governance team to encourage positive change; change in a more active way. We also commit to publicly ‘naming and faming’ companies that are stepping up and succeeding in this transition, including oil companies, banks and utility companies. Believe me, these companies are very interested in how they rank amongst their peers!
(1) Source: IPE Research 2016; (2) Source: LGIM internal data as at 30 June 2016. These figures include assets managed by LGIMA, an SEC Registered Investment Advisor. Data includes derivative positions; (3) as at 30 June 2016
ESG and corporate governance focus: LGIM has shown industry leadership on ESG issues. We use our scale to influence company behaviour on behalf of our clients, striving to achieve positive financial and societal impacts through our investments.
A leader in index fund management: we are one of the largest global providers of index funds, with over €361bn AUM(3)
Tenth largest asset manager worldwide(1), with €1,125 billion of assets under management(2)
As the largest UK manager of institutional assets(1), LGIM has significant experience in index fund management and factor-based investing, alongside a firm commitment to corporate governance issues
The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested.
The information contained in this document has been prepared by Legal & General Investment Management Limited on behalf of Legal and General Assurance (Pensions Management) Limited.
This eBook is issued by Legal & General Investment Management Limited and Legal and General Assurance (Pensions Management) Limited.
Legal and General Assurance (Pensions Management) Limited. Registered in England and Wales No. 01006112.
We are authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Head of Sustainability and Responsible Investment Strategy
Meryam joined LGIM in 2008 to set up a business proposal team and project managed various marketing and sales initiatives across a wide range of products and capabilities. After completing an MSc in Environmental Decision Making, she joined the Corporate Governance team in 2010 to establish the engagement programme on environmental and social topics as LGIM signed up to the UN Principles of Responsible Investment and the UK Stewardship Code. Meryam is responsible for engaging on sustainability themes globally and development of responsible investment product solutions.
Head of Unit Trust Relationships
Nancy is Head of Unit Trust Relationships with responsibility for LGIM’s institutional non-profit clients. Nancy joined LGIM in 2015 from Schroders, where she held the title of Portfolio Director for four years, with responsibility for managing investment portfolios on behalf of Foundations and Endowments. Nancy graduated from the School of Oriental and African Studies (SOAS) with a BSc in economics in 2002. She holds the Investment Management Certificate (IMC) and is a member of the Chartered Institute for Securities and Investments (CISI).
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