Sustainability in Defined Contribution: Implementing for the long term

08-Jun-2020

Capital at risk. This information should not be relied upon as investment advice, or a recommendation regarding any products, strategies. The environmental, social and governance (“ESG”) considerations discussed herein may affect an investment team’s decision to invest in certain companies or industries from time to time. Results may differ from portfolios that do not apply similar ESG considerations to their investment process.

When I started writing this blog, I was determined not to talk about COVID-19. On reflection, that was a fruitless effort. Not mentioning the pandemic would have been comparable to denying that we’re living through extraordinary times.

And yet, for all the focus on the responses to the crisis, it has not gone unnoticed to me that we’re also witnessing an increased interest in sustainable investing amongst UK pensions investors (Source: XPS Pensions Group, January 2020).

For someone working in sustainable investing, COVID-19 has inadvertently given me the chance to step back and look at “ESG (Environmental, Social and Governance)” with fresh eyes. We have seen how the temporary (and, hopefully more permanent) reduction in carbon emissions, has cleansed the riverways of Europe and reduced the air pollution levels in the cities of India and China. We have also noticed that our collective increased scrutiny of how companies have been treating and interacting with their workforce during the crisis– allowing us to reflect on “purpose” and the little brother in the room - the “S.”

The way we invest is being directly impacted by all this.

In the case of UK Defined Contributions (DC), things have moved even faster.

There is an increased understanding, and desire, to move closer to a framework that Nordic pension schemes have operated at for the past 10 years. For UK DC, the time to make the move to ESG appears to be now.

However, I want the conversation to move away from the well-trodden “what ESG methodology” should a UK DC scheme use. That is something specific to each scheme, and there are many screened and ESG index options available in the market for people to choose from. What to me would be more pertinent to focus on are the considerations around long-term investing.

The time is nigh – how to do it?

At BlackRock we believe that investors should choose ESG when they believe it will deliver better risk adjusted returns over the long term.

RISK: There can be no guarantee that the investment strategy can be successful and the value of investments may go down as well as up.

What has been really interesting to realise in my conversations with large UK DC schemes and default providers over the past 6 months, is that we are seeing “active views” being taken – where clients move past the more general “ESG” concept and start taking specific views on climate change as an investment risk, or overweighting their investments with strong governance ratings.

This reveals an investment conviction in the materiality of risks and opportunities.

The Department for Work and Pensions (DWP) requirements for the consideration of non-financial material factors has driven the need for the consideration of what trustee’s believe are E, S and G risks and opportunities in their portfolios.

Sustainable funds (particularly optimised ESG indexes favoured in the UK) have now had their first market crisis with which to score them – and crucially, for the most part, have performed as we expected them to – i.e. they have demonstrated a resilience akin to the quality and minimum volatility factors we have long known and have had a positive correlation to ESG ratings.

But it is not easy moving allocations – particularly as the focus remains (and will do so for the time being) on the large global passive equity exposures that make up growth phases (Source: BlackRock as at June 2020).

There is, of course, a cost implication to this. In terms of investment products, nothing is as cheap (management fee) nor as efficient (additional expenses) as a Market Cap index – in some cases, the fees associated with investing in an ESG index fund might be two or three times higher than the traditional market cap parent index.

This is where having conviction in ESG is important – why pay more if you don’t believe in ESG or at the very least if your members are not asking for it? The DWP are certainly not forcing it (yet!).

What we have seen over this cycle is that additional cost may be rewarded in performance (or through minimising the downside). When you take the longer term horizon of DC members in growth phases, more and more of these E, S and G risks begin to manifest.

We have been through this process ourselves when deciding that our UK target date range, LifePath, was ideally suited to the long-term view of an ESG fund to deliver its global equity exposure.

We did not want to make one large transition, as that would have incurred high costs. So, we decided to allocate over time using the new flows from contributions and building the allocation that way. It was a long-term investment view and therefore by approaching it that way LifePath members receive the benefit of the research led investment, whilst not being impacted by the higher cost.

Find out more in our Sustainable investing: Resilience amid uncertainty paper.

Conclusion

My suggestion to investors is for them to consider if they believe that E, S and G risks are material enough for them to do something about it.

Understanding why they are investing in a specific ESG fund makes the implementation easier. It does not all have to be on day one. Allocation through contributions can reduce cost and ESG can pay for itself through performance, if investors are willing to consider the long-term. It is with a simple investment premise of understanding the materiality of E, S and G risks that BlackRock are dedicating our research to.

We believe that in these extraordinary times, there will be change and, if now is the time to invest in ESG, then we can help our clients navigate that change as smoothly as possible.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are by BlackRock as of June 2020 and may change as subsequent conditions vary.

Sam Tripuraneni
Vice President, member of the BlackRock Sustainable Investing team in EMEA
Sam Tripuraneni is a member of the BlackRock Sustainable Investing team in EMEA. He works closely with the firm's global investment and client business teams to develop ...
Read more