Anais Caldwell-Jones discusses the important questions ‘why should I consider a passive climate tilted equity fund?’, ‘how does a passive climate tilted equity fund work in practice?’ and ‘what would a passive climate equity fund portfolio look like?’.

Why should I consider a passive climate tilted equity fund?

The last few years have seen increasing focus from individuals, institutions and governments on the environment and investing in a climate aware manner. The International Energy Agency predicts we will release 47 billion tons of carbon globally in 2020, only 4 billion less than in 2019 despite global lockdowns and the shift to an online world.

Covid-19 is awful. Climate change could be worse.

Investors are increasingly assessing how companies’ climate practices will impact their share price over the long run with regulators paying more attention to climate factors. Large asset owners are expected to disclose their climate practices by 2022 and pension schemes must already consider and detail their approach to environmental factors in a Statement of Investment Principles.

Many of our clients choose to invest their equities passively, given the lower fees, lower governance and lower level of manager risk passive funds have compared to active managers. Replacing all or some of your passive equity allocation with an investment in a climate tilted fund can provide protection against climate risk and help meet increasing regulatory requirements, while only introducing a moderate amount of tracking error versus a traditional market capitalisation global equity benchmark.

How does a passive climate tilted equity fund work in practice?

Such funds typically start with a market capitalisation global equity index and assess the individual stocks in that index based on various climate factors. A tilted index is then calculated by increasing the weight of stocks that score well from a climate perspective and reducing the weight of those that score poorly from a climate perspective, and the fund tracks this index (see diagram).

Carbon emissions and fossil fuel reserves used are two of the most common inputs used in climate tilted equity funds. More detail on inputs that are used in such funds are set out in the table.

A climate equity fund is naturally quite data intensive, so good quality data (which often would be sourced from a specialist third party provider) is key. This is especially the case for passive management where unlike active management there’s no human judgement at the portfolio construction stage.

What would a passive climate equity fund portfolio look like?

The chart shows the weight of different GICS (Global Industry Classification Standard) sectors in a global market capitalisation weighted index and each sector’s contribution to total carbon emissions emitted in a year.

This reveals a huge divergence in the share of carbon emissions generated by sector. For instance, the utilities sector emits over 30% of total carbon emissions despite constituting only around 2% of the index by value.  The IT sector by contrast emits only 1% of emissions despite constituting around 24% of the index.

Passive funds can both tilt towards sectors which are more climate friendly but also adjust the companies they invest in within sectors.  For instance, within the US consumer services sector, Netflix might be preferred over Walmart as Netflix produces less carbon emissions per $m of revenue than Walmart.

The benefit of tilting within sectors is that the sector composition of a climate tilted equity fund is not distorted versus a traditional global equity index, helping ensure tracking error is relatively modest.  For instance, a large tilt towards technology companies at the expense of energy companies would have created a high level of tracking error this year given the divergent performance of the two sectors (albeit a positive one!).  By using a combination of stock-level tilts and sector constraints it is possible to create a climate tilted equity index which reduces carbon emissions intensity by (say) 70% on day one whilst maintaining moderate tracking error versus a market cap index.  We would expect a climate equity index fund constructed like this to outperform a regular passive fund if markets price in climate risk, while the use of tilting within sectors helps to reduce the risk of the fund materially underperforming due to sector divergence.

If you invest in traditional market capitalisation weighted passive equity funds, we recommend you discuss options to invest in climate tilted funds instead with your investment consultant.  This may be a simple way to protect against climate risk in your equity allocation, whilst also meeting increasing regulatory expectations.  As Bill Gates’ quote indicates, the risks of not acting may be far greater than the risks of switching.