Do Pension Funds Seek Free Lunch When Investing in ESG ETFs?

Do Pension Funds Seek Free Lunch When Investing in ESG ETFs?

Majority of pension plans have low tolerance for high tracking error.

Reviewed by: Theo Andrew
Edited by: Theo Andrew

LONDON – Pension funds are looking for a “free option” when using ESG ETFs in their portfolio with a majority having a low appetite for high tracking error, according to a survey conducted by CREATE Research and DWS.

The survey, which interviewed 50 of the world’s largest pension funds with assets under management of €3.3trn, found 60% aim to mimic their parent benchmarks completely.

Of those, 54% only accepted a tracking error of below 1% while 6% accepted no error at all.

Despite most respondents seeing ESG investing as a long-term endeavour, many see the low tracking error as a “baseline performance expectation” of their chosen parent index.

“However, by reorienting their passive portfolio towards impacts, our participants expect to see some demonstrable upside without sacrificing baseline outcomes,” the report said.

“In other words, they are seeking a free option, which gives an upside as markets start to price in impact risks and downside protection against capital loss if it does not.”

Elsewhere, 26% said they have a tracking error in the range of 1-2.9%, 10% are in the range of 3-49% and 4% have an error of 5% and above.

“The implication is that index constructors have to be pretty smart in their choice of constituent companies if they are to deliver added value on top of baseline benefits,” it added.

Highlighting this, pension funds mostly use broad indices that employ ESG metrics with relatively low tracking error to their parent index. Currently, 22% said they use broad-beta ESG indices, a number that will likely rise to 24% within the next three years.

However, their share of the market is likely to eclipsed to more “impact” related dark-green ETFs that are classified as Article 9 under the Sustainable Finance Disclosure Regulation (SFDR).

For example, the number of pension funds using the European Union’s Climate Transition benchmark and Paris-aligned benchmarks could double from 14% to 28% over the next three years.

Meanwhile, those using ETFs classified as thematic sustainable development goals-related indices will jump from 18% to 28% over the same timeframe. Pension funds using green, social and sustainable bond indices will also grow from 22% to 26%.

Amin Rajan, chief executive of CREATE Research, said: “Pension funds increasingly see it as their duty to contribute, on behalf of their pensioners, to mitigate the negative effects of past economic development on the environment, climate and biodiversity. There is still a long way to go, but the important first step has been taken."

It comes as research suggests investments of up to $100trn will be needed to reach the net zero target by 2050, while an annual investment of $5trn to $7trn will be required to implement all 17 United Nation’s Sustainable Development Goals by 2030.

It comes as many asset managers scramble to upgrade the SFDR status of many of their products. In Q2 this year, 700 products switched their SFDR status with the majority upgrading from Article 6 to Article 8, according to Morningstar.


[Editor’s note: This article originally appeared on ETF Stream]

Theo Andrew joined ETF Stream as a senior reporter in September 2021. He has over four years of investment writing experience spanning pensions and retail investments, most recently at Citywire, where he was a senior reporter covering environmental, social and governance investing.