From ethical investing to ESG integration to impact investing, we are seeing a meaningful shift in investor behaviour that will inevitably change both the investment business and the structure of global financial markets. Here, I want to discuss the effect on our concept of “beta”.

Why exclusions matter

Exclusions have had mixed reviews in recent years, and the debate around engagement versus exclusion persists. However, when Tabula conducted an investor survey earlier this year and we asked professional investors what features they looked for in an ESG ETF, “exclusions” was the top answer (see chart).

What lies behind this is a growing consensus around some minimum basic standards, such as compliance with the UN Global Compact and avoiding manufacturers of controversial weapons.

This can be summarised as the “Do No Significant Harm” or “DNSH” principle. While engagement makes sense in some sectors, and particularly for equity investors, some companies and some kinds of business activities are just not ok. Fixed income investing is more suited to exclusions. As a bond investor, you vote with your feet. Issuers are in the primary market continuously. If they cannot fund themselves, they will change their behaviour.

What does this mean for "beta" as we know it?

Until recently, index providers have been hampered by the range of views on exclusions. They have introduced multiple ESG versions of major indices catering to different ethical or religious viewpoints but have generally left their “flagship” indices unchanged. Now, however, although the range of views remains, the investment community is in increasing agreement that certain companies or issuers do not belong in any portfolio. What we think of as beta is already changing.

The rise of passive investing and widespread use of major indices as benchmarks, in research and in the media means that, for many investors, beta is the index. However, with ESG, investors are leading the way and it is the index providers who need to catch up. Just as indices have always included liquidity filters to ensure “investability”,

I hope that all major benchmarks will soon incorporate basic ESG filters to ensure responsible “investability”. For ETF providers like Tabula, a core component of the ESG strategy should be to lobby index providers to make these changes. We have had smart beta; what we need now is “better beta”.

How much does tracking matter?

Many existing ESG indices aim for a risk profile closely matched to their parent index. A few years ago, when ESG was less mainstream, some investors probably needed the reassurance that a shift in assets would not result in significant tracking differential or a major performance difference. Today, we talk to many investors who are convinced about ESG – particularly basic exclusions or “DNSH” - and less concerned if it causes performance to diverge.

Perhaps the relevance of traditional benchmarks is already waning? The day when tracking error is defined relative to an ESG benchmark, as the rule rather than the exception, cannot be far away.

Where do the EU climate benchmarks fit in?

The European Commission clearly hopes and expects their new low-carbon indices to become the market standard. The EU Technical Expert Group described Paris-Aligned Benchmarks, which require a 50% initial reduction in GHG footprint relative to the broad market and a 7% year-onyear reduction, as “favouring today the players of tomorrow’s economy”. Perhaps these Paris-Aligned Benchmarks are “beyond beta” in the shorter term but a good indication of where forward-looking investors could direct assets.

Nevertheless, two features of the EU Climate Benchmarks are particularly relevant to this discussion around beta. Firstly, while focusing on climate, the benchmarks also require basic exclusions that broadly reflect current investor consensus: no companies who violate the UN Global Compact and other societal norms; no manufacturers of controversial weapons and no tobacco companies. This is a sign that what is currently best practice could end up as law, and the clear direction of travel for “beta”.

Secondly, these benchmarks are designed to help investors align their portfolios with a 1.5C Paris climate scenario. Despite similar sector exposures, they are quite different in composition and weighting to their traditional counterparts.

However, if the broader market is able to reduce emissions in line with the Paris commitments, then the EU Climate Benchmarks would gradually become more similar to the broader market. In an ideal world, where the Paris commitments are met, these EU Climate Benchmarks would converge towards market beta.

In the meantime, however, the differing exposures could generate opportunities. Another interesting conclusion from our survey was the demand for outperformance from ESG strategies. Meeting the Paris climate commitments will require significant change, potentially driven by regulation. In this case, investors who have focused on companies with lower climate-related risk could see better performance.

Fixed income could lead the way

Traditionally, fixed income has lagged equities in passive investing and ETFs. It is a complex asset class, where indexation has been challenging. With ESG, we believe that fixed income can and should lead.

Firstly, exclusion is potentially more powerful than it is in equity markets. As a passive bond investor, engagement opportunities are limited. We can join collaborative initiatives like Climate Action 100+ (and Tabula is actively doing this). However, the regular issuance cycle in bond markets means that exclusion – effectively withholding funding – can potentially influence issuer behaviour.

Secondly, the growth in green, social and sustainable bonds presents an opportunity to define markets by impacts as well as by traditional countries and sectors. Fixed income indices and ETFs could lead the way as the market looks to redefine beta.

Michael John Lytle is CEO of Tabula

This article first appeared in the Q4 2020 edition of Beyond Beta, the world’s only smart beta publication. To receive a full copy, click here.