Robin Kollannur, Managing Partner at ScopeFour Capital, explains the importance of choosing appropriate benchmarks for climate-oriented equity strategies.
Although sustainable strategies have long been incorporated into and considered for public equity allocation, climate-specific strategies that focus on mitigation are a newer part of the investment landscape. The value proposition for climate-oriented public equity strategies typically consists of two components: deliver strong climate characteristics and outperform broader equity markets over time. Examples of climate characteristics to look for include a threshold for sustainable revenues, quantification of direct and indirect emissions (Scopes 1-3) and carbon intensity (how much carbon is emitted as a unit of sales). Ensuring that appropriate benchmarks are assigned to measure these strategies is a critical component of the investment process, as benchmarks play a vital role in setting investor expectations for risk and reward.
Institutional investors that manage, allocate to, or evaluate climate strategies tend to default to widely accepted broad equity indices, such as the US-based S&P 500 or the global MSCI ACWI Index. While the near-monopoly status of these indices often leads to an instant assumption they should also be applicable to climate strategies, they were not constructed with climate characteristics in mind. Almost all the broad equity indices are weighted according to the stock’s market capitalisation, or ‘cap-weighted’. This causes a considerable mismatch between benchmark constituents and the true climate opportunity set.
For example, the top holdings of both the S&P 500 and MSCI ACWI include Apple, Microsoft, Amazon, Meta, Nvidia, and Google. While these companies have made climate commitments and can help garner broader support for decarbonisation initiatives, the majority of their product lines are not tied to climate solutions. Climate solutions are defined as any product or service that mitigates or adapts to climate change. Uncovering the companies that Apple and Microsoft are hiring to enable their internal decarbonisation efforts may also provide strong investment results over the long-term and be more appropriate for inclusion into a climate strategy.
A climate-oriented equity strategy should have strong climate materiality, defined as strong alignment between sales and profits and tangible climate solutions. The climate strategy should also have specific climate-oriented catalysts for stock price appreciation for each one of its underlying holdings. If Apple and Microsoft were held in a climate strategy due to their inclusion in the strategy’s benchmark, and those stocks appreciated in value due to investor interest in smartphone sales or software subscriptions for example, the climate strategy would be right for the wrong reasons. The stock price appreciation would have very little to do with their climate efforts, and the climate strategy would not be staying true to its original mandate by taking credit for that outperformance.
Using a broad-based index for climate strategies may also create higher tracking error and mismatches by country and sector. For example, in 2023, exposure to US-domiciled companies in the MSCI ACWI Index hit a historical high of 61% due to excessive outperformance in mega-cap names. Broad indices also typically hold large weights to sectors that may not have a strong positive climate impact, such as financials and health Care.
Over the last decade, passive inflows have grown to surpass actively managed strategies, and cap-weighted indices have exacerbated this trend. It is reminiscent of an ancient symbol of a snake eating its own tail, the Ouroboros. The Ouroboros was meant to signify infinity and the circle of time. In this case, the snake is the cap-weighted index, and the tail is the associated ETF or fund that tracks it. As passive flows continue to increase, it tempers natural price discovery as these funds are buying the underlying names at amplified weights regardless of risk, valuation, or any climate-related metric. These flows force concentration into a narrow set of names or countries, and therefore result in a lack of diversification and higher aggregate risk, which is amplified during a market downturn.
History has proven this in many instances:
- During the height of its asset bubble in 1988, Japan was over 60% of the market-cap weighted MSCI EAFE Index. After the bubble burst, the weight came down to roughly 20% in the 1990s and is still in the same range today.
- The information technology (IT) sector is roughly 29% of the S&P 500 Index as of 4Q 2023. It is important to note that the investment industry implemented a GICS sector reclassification in 2018 that impacted most global indices and many of its largest constituents. For example, Alphabet and Meta were moved from the IT sector and inserted into the communication services sector (formerly telecommunications). Adding these two companies back to IT today would bring its weight closer to 35%, which is higher than the 33% IT weight reached at the height of the dot.com bubble in the late 1990s. After the bubble burst, the IT weight went down under 14% and only came back to 29% in 2023.
In conclusion, climate strategies should be monitored not only for performance relative to a benchmark, but also for incorporating specific climate characteristics and measurements to determine whether they are consistent with their original mandate. Broad market indices are currently the preferred default options but are potentially risky choices, given their cap-weighted construction methodologies, the rise of passive flows leading to a lack of diversification, and the lack of a climate-specific orientation.
Optimally, a benchmark should be chosen that has been built on climate characteristics specified in advance, has strong alignment with the climate strategy’s investment philosophy and process, and is closely representative of the strategy’s investable universe. Investors can choose a climate-specific benchmark accordingly, create a custom index that mirrors the underlying strategy’s mandate, or even use a blend of board market and climate indices (which is common for fixed income and multi-asset strategies).