The risk of being ‘good’:
Integrating Responsible Investing and Enhanced Indexing
Access to information contained on this website is exclusively reserved for professional investors in United Kingdom. Please read the important information below. This contains legal and regulatory information which applies to our company status, use of this website and information about any investment in our products referred to in this website. Note that you will have to accept these terms and conditions before you can proceed. Copyright 2021 by Nordea Investment Funds S.A. – all rights reserved.
Access to information contained on this website is exclusively reserved for investors in United Kingdom. Please read the important information below. This contains legal and regulatory information which applies to our company status, use of this website and information about any investment in our products referred to in this website. Note that you will have to accept these terms and conditions before you can proceed. Copyright 2021 by Nordea Investment Funds S.A. – all rights reserved.
Here’s the dilemma: Index Investing exposes investors to the entire Index, warts and all, while any deviation puts investors on the path to active management. Therefore, incorporating Responsible Investing cannot be passive, it is an active investment decision and, in most cases, implicitly assumes that ‘good’ ESG companies are also ‘good’ investments. This in turn creates a risk that the resulting Responsible Investment portfolio does not deliver the risk nor the Index return. Some investors can live with this, while others, who want a passive investment to the Index whilst doing ‘good’, can’t.
If your aim is to replicate the Index by only investing in ‘good’ ESG companies, as a ‘passive investor’ you take on that Tracking Error risk. This may seem trivial or a small ‘price to pay’, but ‘bad’ ESG companies have delivered significant historical outperformance. In the meantime, thematic solutions around climate change and ESG have also performed very strongly since the global financial crises.
The continuation of this outperformance could be challenged by investors recognising the true risks of ‘bad’ ESG practices, steering capital – both equity and debt – towards a Responsible Investing agenda. Also, we see a dramatic change in behaviour of the consumers, as they want products and services that are environmentally sustainable, so companies are changing. In addition, our own Central Bank, the Bank of England, has explicitly made the link between the impact of economic activities on the environment and the impact that the environment can affect the global economy.
Evidence shows that outperformance of ‘bad’ ESG companies can be explained by a combination of factor exposures and the requirement for ‘bad’ ESG companies to deliver a higher return given the higher risk tolerance needed to invest in these companies. Companies with high ESG scores exhibit positive exposure to the low volatility and quality factors and negative exposure to the value and size factors. Therefore, by excluding ‘bad’ ESG companies the portfolio is short potentially attractive factors and is demonstrably different from the Index by not only having different country and sector exposures, but also factor exposures, which can result in a sizable tracking error. The remedy to this unintended factor, country and sector exposure may be restored by investing in companies with offsetting exposures.
The good news is that a Responsible Investment portfolio can achieve the risk and return of the Index; but investors must accept that this is not a passive investment. Once this point has settled, the next step to replicate the Index with a Responsible Investment portfolio is to determine the best way to utilise the Tracking Error that has been generated.
First, let’s define what could be considered a Responsible Investment portfolio.
According to Nordea’s Multi Assets Team, a strong Responsible Investment portfolio should have an ESG average rating of at least A, and exclude companies that:
The remaining universe after these exclusions is about 1800 companies in MSCI All Country World Index (ACWI). In other words, about 1000 companies, out of 2850, have been excluded. This may seem excessive… but, in our view, incorporating ESG scores is only one part of being a Responsible Investor.
The universe should now only contain ‘good’ companies, but as mentioned earlier, ‘good’ companies are not necessarily ‘good’ and outperforming investments, as this Responsible Investment Universe makes no explicit alpha assumptions about the ‘good’ companies, or even about the companies excluded. The removal of ‘bad’ companies can create long-term value by reducing risk, but this simply concerns risk management. So, how can we select ‘good’ investments from a ‘good’ universe to deliver the Index risk and also its return?
At Nordea we believe this can be achieved through Enhanced Indexing.
As an example, our Sustainable Beta+ Strategy aims to deliver the risk and performance of the MSCI All Country World Index¹ . The companies exclusion criteria are exactly as outlined above. Through our Enhanced Indexing approach, which we call Beta+, the aim is to achieve alpha by utilising a low level of Tracking Error. It’s this alpha that allows us to be confident that we can deliver the Index return; it also helps cover the costs of managing the portfolio and thus achieves the index return after transaction costs and fees. Unlike passive investing.
How does our Enhanced Index approach determine ‘good’ investments within a ‘good’ universe
Firstly, it’s important to highlight that the strategy aims to generate most of the excess return from company selection. Beta+ uses both risk premia and a proprietary company selection methodology that has proven to be indicative of future excess return. We also filter out from this ‘good’ universe companies that are expensive, low quality and have deteriorating earnings or cash flows. These could be called the ‘uglies’ and our evidence shows that we can generate alpha from avoiding these ‘ugly’ companies.
Putting it all together: the Nordea Sustainable Beta+ Strategy incorporates a comprehensive Responsible Investment screening to identify ‘good’ companies, we then apply our Beta+ process to select ‘good’ investments within the ‘good’ companies. Meanwhile, we keep sector and region risk tightly controlled to deliver the MSCI All Country World Index return, net-of-fees.
In conclusion, it is possible for a Responsible Investor to track the Index risk while also matching the Index return.
¹There can be no warranty that an investment objective, targeted returns and results of an investment structure is achieved.
The value of your investment can go up and down, and you could lose some or all of your invested money.Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A. and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and representative offices. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management AB recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Nordea Asset Management has decided to bear the cost for research, i.e. such cost is covered by existing fee arrangements (Management-/Administration-Fee). Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and representative offices are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source: Nordea Investment Funds S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and representative offices. This document is furnished on a confidential basis and may not be reproduced or circulated without prior permission and must not be passed to private investors. This document contains information only intended for professional investors and eligible investors and is not intended for general publication. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or representative offices.