By the ETF research team at Lyxor Asset Management.

The case for index investing to tackle climate change

When a decision has been made to invest in line with climate or ESG considerations, an investor is faced with an important choice: active manager or index fund?

Some argue active managers are best-placed to implement sustainable strategies such as environmental, social, and governance (ESG) or climate change investing because they can make considered decisions to buy or sell companies based on observed behaviours. Others maintain that index funds can achieve the same goals in a transparent and rules-based way for a fraction of the cost.

As the money invested in climate-friendly and socially-responsible strategies rises, it becomes more important to investigate which approach works best for achieving certain investment goals. On this question rely major pools of capital that could make a significant contribution to a sustainable future for the planet.

In this article, we outline three factors that we believe support an index-based approach for climate and ESG investing, in 2020 and the decades beyond.

Reason #1: Better data means indices now match even advanced sustainability goals

Thanks to improvements in data quality, investment indices today can be built to reflect all sorts of climate and ESG policies – then make them accessible to investors at a low cost.

Innovations in this area include exclusionary screens that filter out, as an example, companies that consume or extract high amounts of thermal coal. They include the implementation of specific values such as gender equality, or stock selection based on carbon ratings, or alignment with the UN’s Sustainable Development Goals (SDGs). All these varied objectives and more are now codified in indices, meaning most sustainable investment objectives may now be achieved using an index-based approach.

The variety of new sustainable indices means they could be used in a variety of new ways; as portfolio cores, for example, that could substitute traditional market-capitalization-weighted indices for ones that weight by ESG scores, with limited tracking error. Some values-orientated or broad sustainability indices may be used as diversifiers whenever implementing those convictions justifies a higher tracking error.

Overall, better data means better indices and more ways to invest with an index-based approach in a transparent, low-cost, and rules-based way – all important considerations for investors looking to generate long-term sustainable performance.

Reason #2: Indexing makes sustainable investing scalable

Much of sustainable investing practice is focused on ‘impact’, which means assessing an investment’s social or environmental effect alongside its financial return.

Impact investing is often associated with private loans and private equity, where active funds are clearly well-placed to play a role. Yet, the same principles that support investing in private assets – intentionality, additionality, measurability – are also reflected in the publicly-listed assets generally tracked by ETFs.

And because listed assets have higher liquidity than unlisted ones, an index investor can mobilize larger amounts of capital and make it work towards their ESG goals.

Some examples of how Lyxor’s ETFs help investors deploy capital towards important sustainable goals include our funds contributing to UN SDGs, which invest to support climate action, water, clean and affordable energy, and gender equality. Our ESG Trend Leaders range invests in companies with a rising ESG trend, not only the best-rated ones, as we believe it makes more impact to reward companies actively making changes.

Reason #3: Good passive managers have an active voice

One concern among investors comparing active and index-based strategies for sustainable investing is shareholder engagement: can a passive investor really hold portfolio companies to account?

Some passive managers, including Lyxor, have tackled this by setting up voting policies like an active manager. These policies and voting records are public and the manager is accountable to fund holders. In Lyxor’s shareholder engagement policy it also involves a direct dialogue with companies to communicate expectations, for example with respect to governance.

In our updated 2020 voting policy, we have upped the ante for company engagement, with climate change considerations, in particular, taking a more prominent role. We may now refuse to grant discharge to a board of directors or to approve the reappointment of members in the case of environmental controversies or a lack of transparency concerning greenhouse gas emissions. From 2021, we may also refuse the chairman re-election of any board where the company refuses to uphold the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), a framework designed to help companies and ESG investors better manage their exposure to climate risks and opportunities.

On top of that, Lyxor will be able to vote against resolutions concerning executives’ compensation if extra-financial measures have not been sufficiently considered within remuneration policies.

This shows it is possible to encourage sustainable business practice with index investing – if that investment is with a responsible ‘active’ passive manager.

More choice means more ways to achieve sustainable investment goals

The combination of better sustainability data, the scalability of index-based investing, and the power of company engagement by major passive managers means investors can confidently use index-based strategies to achieve sustainable investment goals.

Here at Lyxor, we have made it our mission to provide investors with all sorts of index products that increase the options for climate, ESG, and values-based investing. Our pioneering Green Bonds ETF invests only in green bonds approved by the Climate Bonds Initiative, ensuring proceeds are strictly earmarked to pro-climate projects and assets.

Similarly, where the landmark Paris Agreement committed the countries of the world to limit global warming to “well below” 2°C and “pursue efforts to limit” it to 1.5°C above preindustrial levels, research is demonstrating that there are major differences in the outcome of +2°C versus +1.5°C for the sustainability of human ecosystems, and rules-based indexes can be designed to match this most ambitious target.

Our climate transition ETFs launched this year are designed to help investors meet this goal by starting their climate transition plans right now, using core equity indices built by S&P and MSCI. These benchmarks give higher weights to companies with a capacity to manage and contribute to climate transition through the reduction of carbon emissions.

In the same way that the $6.7tn ETF industry caused an unquestionable shift in the investment landscape, we’re delighted to see a shift of similar scope towards better, greener portfolios. Choices now abound for long term investors seeking to invest sustainably, and index investing has many benefits in the fight against climate change that make it worth taking seriously.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)