Mark Thompson explains how to provide protection against climate risks, and champions more environmentally sound corporate governance
The trustee of the HSBC Bank UK Pension Scheme wanted to construct a better defined contribution (DC) default fund. So working with FTSE Russell, Legal & General Investment Management (LGIM) and the investment consultant Redington, we set three main objectives:
Better risk-adjusted member outcomes:
- Exposure to systematically designed portfolios (known as factor investing) can offer long-term rewards to members.
- Protect members against climate change consistent with the trustee's fiduciary duty: More than half of the scheme's DC members are less than 40 years old and need protection from long-term emerging risks.
- We believe that climate change will have material economic implications on the value of companies, necessitating action to reduce such risks at a portfolio level.
- Enhance environmental, social and corporate governance (ESG) engagement within a passive mandate: We see driving positive long-term change as a key part of fiduciaries' responsibilities.
Better risk-adjusted member outcomes
We researched factors that offered enhanced risk-adjusted returns compared to market capitalisation weighted indices. The four factors we selected were: value (companies that look relatively cheap), low volatility (companies that have lower risk but offer improved risk-adjusted returns), quality (companies that offer stable dividends) and low size (smaller companies). Momentum (trading with the direction the market is moving) was excluded for a number of reasons such as the high rate of turnover and therefore transaction costs that it would have implied.
In combination and with a similar exposure to each chosen factor we developed the Balanced Factor Index.
The Balanced Factor Index delivered a higher return than the FTSE All World index (9.59% pa vs 7.05% pa) with lower volatility (14.79% pa vs 16.29% pa) between September 2001 and March 2016. We believe that the approach will deliver a better risk-adjusted performance in the future too.
Protect members against climate change
The trustee believes that climate change is a significant long-term risk to members' pension investments, and has adopted an explicit climate change policy to help manage this risk. We researched the impact of incorporating climate change tilts (increasing or reducing holdings) into the index to provide meaningful protection, while minimising tracking error against the Balanced Factor Index.
We achieved meaningful reductions in carbon exposure and positive exposure to companies engaged in the Low Carbon Economy (LCE) by developing the Climate Balanced Factor Index (CBFI). The CBFI holds 69% less carbon reserves, 28% less carbon emissions and 105% more green revenue than the FTSE All World Index. These climate change tilts introduce a tracking error of only c. 0.5% pa against the pure Balanced Factor Index.
Drawing from FTSE Russell's factor framework and climate analytics, this approach became The FTSE All World ex CW* Climate Balanced Factor Index that was launched at the market open of the London Stock Exchange on 7 November 2016.
It is a diversified mainstream index, which includes a substantial proportion of constituents of the FTSE All World index (over 3,000 stocks), and incorporates climate change protection objectives by adjusting the constituent weights. The Future World Fund will be a passive fund that tracks this Climate Balanced Factor Index.
Enhanced ESG engagement
The third objective of the fund is to have a positive impact on corporate behaviour. LGIM further stepped up on its already excellent ESG engagement approach by committing to a 'Climate Impact Pledge':
- For the top 80-90 global companies in the six sectors most affected by climate change and energy transition, LGIM will engage with the individual firms to encourage them to develop plans to transition their businesses to a low-carbon future. If, after a year of direct engagement with a specific company, it is not progressing on a medium-term transition plan, LGIM will vote against the chairman at the next annual general meeting. LGIM will vote this way for all of the index assets that it manages, approximately £300 billion.
- The Future World Fund will go one step further. Companies that consistently fail to meet LGIM's minimum expectations will be eventually excluded from the fund. The fund has been given a small tracking error budget of approximately 30bps a year to implement this policy.
Implementing the approach
The trustee of the HSBC Bank Pension Scheme transitioned its DC default fund to this new investment strategy, a fund that is currently valued at approximately £1.85 billion, in January 2017.
We firmly believe that these moves are in the long-term best interests of our members. It gives them a better risk-adjusted return, includes climate change protection consistent with the trustee's fiduciary duty and empowers the fund manager to enhance its ESG engagement policy, fully meeting our three objectives.
Such an approach could find wider applications too. For example, defined benefit schemes are as exposed to climate change as any other long-term institutional investor, and could benefit from the approach we have developed for our DC fund. To make access even easier, we are currently working on developing Total Return Swaps on the FTSE All-World ex CW Climate Balanced Factor Index to provide equity exposure in a leveraged and synthetic manner. This potentially allows all manner of investors to gain from the pioneering work of the HSBC Trustee - and derive the same benefits.
*Note that the ex CW refers to the exclusion of six stocks that manufacture controversial weapons banned under international treaties (cluster munitions and landmines).
Mark Thompson is CIO of the HSBC Bank UK Pension Scheme