NN IP: Sustainable enhanced funds – new options for your investment toolkit

NN IP: Sustainable enhanced funds – new options for your investment toolkit

Duurzaam beleggen
Vermogensgroei.jpg

The massive growth of passive investing styles over the past decade has led to a bewildering array of choices for investors. However, few options are available for investors who want to invest responsibly while staying close to a traditional benchmark. At NN Investment Partners, we have identified a clear need for ‘sustainable enhanced’ solutions that can benefit from the depth of our expertise as an active asset manager with a sustainable focus. We recently launched a range of such strategies, which incorporate active sustainable choices while minimising tracking error. These strategies offer another solution to the growing demand for sustainable investing at the core of investment portfolios.

The strategies in our sustainable enhanced index range are a welcome addition to our existing sustainable equity and impact equity range. They include the NN Enhanced Index Sustainable Equity fund [1], which invests in developed markets, and the NN (L) Emerging Markets Enhanced Index Sustainable Equity fund [2], which invests only in emerging markets. In the coming weeks, we will be launching two additional funds, which will respectively focus on European and North American equities. The funds within this range all follow the same sustainable investment process within the regions in which they invest.

When referring to enhanced index investing, “enhanced” refers to the process of selecting companies that offer more attractive sustainability characteristics. It also means excluding “risky” companies that don’t exhibit good governance or societal behaviour (like treating employees fairly and minimising their environmental impact), while positively selecting for companies that behave in a responsible way. We actively make these sustainability decisions at the start of the investment process, and they are then implemented in a passive-like way by our partner Irish Life Investment Managers (ILIM).

Through our active selection process, we ensure that the funds have a strong sustainability profile and do not invest in companies with serious ESG controversies. Our selection process also rewards companies for good governance and effective climate change policies. As a result, the funds have significantly smaller carbon footprints than traditional index investments.

Sustainability demands active choices

When it comes to building responsible portfolios and integrating ESG factors, it is necessary to make certain active decisions on sustainability issues. Traditional passive funds that simply replicate a benchmark do not incorporate any selection criteria based on sustainability. As a result, they own stocks that are not compatible with a sustainable investment portfolio, and they have less scope to do good by rewarding sustainable companies.

The active management that we integrate into our sustainable enhanced solutions means that investors can incorporate these elements far more effectively in their portfolios. For example, for our global NN Enhanced Index Sustainable Equity fund, we strip out approximately 40% of the original benchmark [3] (reducing the investable universe from 1,650 stocks to 1,050), through a combination of advanced exclusion and positive selection criteria. We take out approximately the same proportion of the benchmark [4] for the emerging markets variant. This is an ongoing process that takes several steps, each of which requires active decision-making.

Blending advanced exclusions and positive selection

In our enhanced investment process, we first remove all the stocks that are on our company-wide restricted list (for example, those with exposure to tobacco) and companies with serious ESG controversies (such as labour rights issues, environmental disasters and/or bribery issues). We also exclude further activities that aren’t in keeping with our sustainable mandate, such as gambling or small arms. Next, we positively select based on carbon emissions. In addition to focusing on current carbon emissions, we actively reward companies that have ambitious targets for reducing their carbon footprints. Finally, we make a positive selection from the benchmark based on governance and other ESG aspects.

Our goal is to keep the tracking error as low as possible following our screening criteria. This is made possible through ILIM’s deep experience in daily index tracking. For the global fund, this leads to a tracking error typically below 1%, while the emerging markets fund has a tracking error between 1% and 1.5%.

As a result of this in-depth selection process, our portfolios are significantly more sustainable than the benchmark, with much lower exposure to potential ESG controversies. Based on our proprietary research,[5] we have found that excluding ESG controversies also leads to stronger risk-adjusted returns (i.e., a higher Sharpe ratio) and thus better performance in the long run (see figure).

Excluding ESG controversies leads to outperformance

Source: European Centre for Corporate Engagement, NN Investment Partners

ESG selection needs clear objectives, in-depth data analysis

We have identified two key considerations for investors contemplating sustainable enhanced index solutions. First, investors need to think carefully about the trade-off between the magnitude of the active sustainability decisions and the available risk budget versus the benchmark. Usually, the more pronounced these choices, the higher the tracking error, the greater the risk-return differential with the benchmark and the more actively the sustainability focus in a portfolio can be managed. Investors should have a clear idea of what kind of trade-off they are prepared to accept when it comes to active sustainability choices and deviation risk from the benchmark (which could be positive or negative). We believe our funds offer an attractive trade-off in this respect.

Second, it is crucial to keep in mind the biases and pitfalls associated with ESG scores and ratings. Asset managers often use data in a highly systematic way to make investment decisions that are then implemented passively. As a result, it’s necessary to carefully assess the quality and diversity of data before integrating it into the investment process. Most third-party data sets have a market cap bias that favours larger companies (which have more resources to report on ESG). There is also a low level of correlation between ESG scores at different providers – even for the same company. Simply taking scores from an external provider without effective analysis can lead to a portfolio that doesn’t have the expected sustainable characteristics.

Effective ESG analysis takes considerable resources and expertise. At NN Investment Partners, our deep experience as an active responsible investor enables us to effectively screen for issues and thus create more sustainable enhanced solutions. Throughout our investment processes, we dedicate significant time and effort to researching and selecting the best ESG data. We use a unique combination of multiple data providers who are leading specialists in specific fields, as opposed to products based on a single data provider. We also monitor continually for serious controversies and re-evaluate our sustainable choices on a quarterly basis. In this way, we ensure an optimal combination of up-to-date ESG data blended with minimal trading costs.

Integrating sustainability at the core of traditional portfolios

Taking an active approach or opting for a passive alternative is one of the most fundamental choices for investors. The goal should always be to find a solution that matches their overall investment beliefs and risk-return requirements. We believe that responsible investing always requires active decision-making, but there is a wide spectrum of options for investors seeking to do good in the world. Following the huge growth of passive investment styles and ESG-focused investing over the past decade, our sustainable enhanced range caters to a specific need in the market. For investors seeking to invest responsibly and diminish ESG risk while minimising tracking error, these funds represent a valuable opportunity to integrate sustainability at the core of a traditional investment portfolio.

[1] Fund names mentioned for illustration purposes only. Please note that the funds may not be registered for distribution in your jurisdiction.

[2] NN (L) Emerging Markets Enhanced Index Sustainable Equity is a sub-fund of NN (L), established in Luxembourg. NN (L) is duly authorised by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Both the fund and sub-fund are registered with the CSSF. The prospectus and the Key Investor Information Document (KIID) (if applicable) and other legally required documents relating to the fund are available on www.nnip.com.

[3] MSCI World Index

[4] MSCI Emerging Markets

[5] Conducted in collaboration with the European Centre for Corporate Engagement