While much ado is made of the science that goes into fund manager research, real assessment puts comparable weight on the art as well according to investment leaders.
While financials and materials dominated trades leading into 2024, the popularity of other sectors like healthcare and information technology followed generational, and even demographic, lines.
Investment to Paris-aligned benchmark challenging, but achievable
Since the Paris-aligned benchmark was introduced in 2016 as a minimum standard for the reduction of greenhouse gases in order to limit global warming, investment houses have struggled with the choice of compliant investment options available. According to Invesco these concerns are only heightened in Australia, but a “layered” approach to portfolio constructions can mitigate the incursion.
The investment giant tackled issues relating to the Paris-aligned benchmark (PAB) in two recent papers; ‘Don’t be blind just because a benchmark is Paris-aligned‘ and ‘Paris-aligned objectives in Australian equities‘, with the latter adding a focus on the challenge wholesale and institutional investors in Australia face meeting the benchmarks while still meeting restraints like best interests duty and the Your Future, Your Super performance test.
Standards set out in the 2020 PAB require greenhouse gas emissions to be 50 per cent below those in the benchmark as well as an annual decarbonisation rate of 7 per cent per annum. Equity allocation restraints also mandate investment in certain basic sectors.
Meeting these targets can be problematic, Invesco says, with the impact on total returns and tracking error issues threatening to keep investors from reaching their goals.
“A key component of the guidelines is the decarbonisation component,” the ‘Don’t be blind…” report states, noting that in Australia 50 per cent of greenhouse emissions come from just 20 companies in the ASX300. The proliferation of mining and resource dependent companies at the top end of the Australian Stock Exchange is a major reason for this. “Divesting from only a handful of companies can significantly reduce the carbon intensity of the portfolio,” it adds.
The problem with simply excluding big mining companies holus bolus, however, is that this can warp overall both risk and performance. “As for exclusions, simple ones could lead to significant biases…” the reports state.
This potential erosion is exacerbated by the fact that ascribing to the PAB automatically means excluding some global companies (tobacco, armaments etc) that flout broader ‘Do No Significant Harm’ EU taxonomy mandates.
When looking at investment options that cater to the standards, Invesco says tracking error is another core issue. “In general, these vendor solutions come with a significant degree of active risk,” one paper states. “The MSCI World PAB alternatives have tracking errors ranging between 0.5 per cent and 2.4 per cent, with significant turnover requirements to add to the overall impact on investors. Many investors cannot tolerate this level of impact.”
To combat the issues, Invesco highlights a two-step procedure.
“First, we constructed a reference portfolio applying the minimum standards used by Paris-aligned benchmarks with a minimal tracking error verses the MSCI World. Then we applied an active multi-factor investment process,” Invesco states.
“This layered approach has several benefits: It distinguishes between the effects of the Paris alignment criteria and the multi-factor management on the risk budget, prevents distortion of the optimal portfolio and bases the factor-focused optimization on a benchmark that already incorporates the climate-related constraints,” it continues. “The resulting portfolio is entirely Paris-aligned, with a beta of 1 to the MSCI World Index and an active risk between 0.6 per cent and 1.3 per cent throughout the simulation history.”
By using these two layers, the investment house describes, investors can fulfil the key criteria of the Paris Agreement without compromising on investment return.
“A layered approach to portfolio construction may balance sustainability preferences with return objectives, providing a flexible and dynamic solution that can be adapted to different investment strategies and asset classes.”
