Passive Portfolios Integral to Pension Funds’ Climate Strategies

Many pension funds still in “early stages” of net zero investing, but expect to use targeted index products to align passive portfolios to Paris goals.

The majority of global pension funds are in the process of integrating climate goals into their portfolios, with many expecting to tilt their passive strategies toward the goals of the Paris agreement, including via use new index products.

However, 60% believe their net zero targets will not be met “under current conditions” according to a CREATE-research survey on global pension funds, sponsored by German asset manager DWS.

According to the report, which is based on a survey of 50 large pension plans across North America, Europe and Australasia, representing €3.3 trillion in assets, pension funds are preparing to adjust both active and passive portfolios to meet climate goals.

A total of 58% of large pension funds said they have already or are in the process of embedding climate change goals, with 42% saying they have or are adopting climate targets for passive portfolios.

More than half of funds (56%) confirmed that passive investment would feature permanently in their climate portfolios, while the same number expected to scale Paris-aligned indices in future.

When asked how the value of the EU’s Paris-Aligned and Climate Transition Benchmark indices to their tilting of their portfolios to climate goals, 52% said they were “very important.”

Climate-based index funds that track Paris-aligned targets will play a large role in passive investing, according to the report, and pension fund investors will increasingly look to use tailored index funds to meet more specific targets, which contrasts to the previous ‘generation’ of low-carbon indices which seek only to reduce emissions.

More work for investors and fund providers

However, according to the survey, when it comes to climate investing via passive funds, traditional indices currently remain the primary vehicle and are used by 42% of respondents, while emerging custom vehicles are used by 28%. The remainder of survey respondents said they used both. Only 22% said they currently use indexes based on the EU benchmarks on a notable scale.

“The survey shows that more pension funds are moving along the path to embracing sustainable investing, including the latest ESG index products,” said Simon Klein, global head of passive sales at DWS. “But more work clearly needs to be done, by institutional investors and investment solution providers, if we are to reach net zero.”

Up to 28% of passive investors said they were still in the “raising awareness” phase of implementing climate investment, according to the report, down from 43% in the 2020 survey.

The research suggested pension funds were seeking to better tailor their index funds to target specific climate change themes, while taking ownership of proxy voting, rather than leaving engagement to their asset managers. Up to 64% of respondents expected active and passive portfolios to co-exist in equal measure, which, according to one UK pension plan quoted in the report, was likely to emerge as the prevailing reality.

The plan’s portfolio ‘core-satellite’ model is constructed so that passive strategies are used across geographies and sectors where markets are highly liquid, whereas active ‘satellites’ cover markets that are illiquid and inefficient, and are used to “harvest” resulting alpha opportunities.

One German pension plan revealed that due to being unfunded, it was prohibited from taking market risks associated with ‘off-the-shelf’ indices, adding that it was currently experimenting with a bespoke index that would allow it to track climate themes of interest to is trustee board, such as biodiversity, carbon footprint, and water management.

Despite current rates of progress, the report said the current strategies of pension plans were set to evolve further in pursuit of climate goals. When asked what actions they were taking to meet targets, 78% said they would be scaling engagement, stewardship, and shareholder resolutions.

Amin Rajan, chief executive of CREATE-Research, told ESG Investor: “The net zero journey only really started last year. Pension funds are still in the early stages, although as the report highlights climate-based investment has been accelerating across the industry for a while now.

“We predict the passive space will catch up, and as it does, Paris-aligned outcomes will be more likely. But companies remain an issue. They are not always consistent with disclosing net zero targets, and many still engage with carbon offset practices which often do not produce desired impacts.”


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