HESTA has funded a new global equities mandate where the strategy is to achieve a 50 per cent reduction in its carbon footprint while minimising the active risk of the strategy compared to the index.

The new strategy has been in place since early December 2015 and Rob Fowler, chief investment officer at HESTA, has described it as an enhanced indexed approach.

“The critical reason we went with this tailoring approach is it was not simply replicating the indices, which we did not think met our needs” said Fowler.

“We didn’t want to replicate the available indices because, as a risk-management approach, we particularly wanted to capture the stranded asset risk, and that required the incorporation of a company’s reserves of fossil fuels, not just their current emissions.”

The $33 billion super fund partnered with Russell Investments in January 2015 to develop a solution which would give it at least a 50 per cent reduction in the overall carbon footprint of the portfolio (and remove tobacco) while replicating the returns of the MSCI ex-Australia, as well as a 50 per cent reduction in exposure to fossil fuel reserves.

Fowler added that what made the mandate tailored was the addition of the value of reserves and carbon embedded in each company.

“That’s something that is not captured in scopes 1, 2 or 3 emissions that companies publish. That’s why we needed something tailored to our needs because, frankly, we wanted to capture the real stranded assets risk, which is that the reserves may never get exploited,” Fowler said.

Given the short time since it has been implemented, there has yet to be any meaningful data gathered on the returns, but Fowler expects it to track close to the index, with the qualification there will be some variation in tracking and returns based on whether the prices of energy, materials and utilities companies are reflecting an energy risk-on or risk-off market.

These sectors are of particular note, because Pareto’s principal – which states 80 per cent of the effects come from 20 per cent of the causes – equally applies to carbon footprinting.

“What that means is a large amount of the carbon footprint is really concentrated in a small number of names and increasingly a small number of sectors within the global equity market. And those sectors are energy, material and utilities,” said Scott Bennett, director of equity strategy and research at Russell Investments.

“Effectively what you have is 80 per cent of the carbon footprint [in equities] comes from 20 per cent of the companies.”

He added this presented a challenge, because screening out those sectors would make the portfolio underweight and introduce more active risk.

The way Russell Investments got around this was to develop an algorithm that minimises the active share between the low-carbon portfolio and the MSCI world ex-Australia benchmark, claiming this achieved a 55 per cent reduction in the carbon footprint.

“By focusing on active share, rather than active risk or tracking error, it allowed us to keep a clear lineal relationship between the carbon footprint and subsequent weight we would hold a stock at within the portfolio,” Bennett said.

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“We didn’t want to build a portfolio construction that would be, say, underweight Exxon Mobile but overweight Shell, and have those two net out, because we wanted to make sure if someone looked at the portfolio they could see we genuinely were underweight high carbon emitters and overweight low carbon emitters.”

Bennett added the approach was a hybrid between an optimised portfolio and a divested portfolio, because of the desire to maintain the strong link between the carbon footprint being the primary driver of the individual stock position, but also the need to have flexibility to take into account things like the sector position and commonality with the parent index.

“We are seeing a lot of demand for these types of solutions from around the world. It’s an area that is getting increasing attention, and it’s an area where those people who can move first are definitely going to be well rewarded.

“No longer does it have to be social versus financial outcome. Through the developments that have been made you can achieve social objectives while also staying true to the fiduciary objective of providing good investment returns.”

Fowler added carbon will eventually get properly priced into the economy and listed companies, so it was important to have a proven portfolio approach: “That will allow us to move a significant portion of our passive global equities into something that will have much less exposure to stranded assets risk and carbon than the standard index”.


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