Emerging passive investing risks a new concern

Investment consultants around the globe are asking their pension fund clients to think carefully about two very real concerns that have emerged in passive investing: ESG-related and concentration risks.

Some pension fund clients have heeded their advice, reconsidering whether they should be implementing some kind of ESG tilt to their benchmarks and in other cases, looking to take portions of the allocation to an active manager instead.

"We are … having exactly these conversations: How much of this risk are people even aware of (that) is under the bonnet of their passive portfolio?" said Andrew Peach, head of factor investing at Aon PLC in St. Albans, England.

Willis Towers Watson PLC also thinks it's time for passive investors to rethink whether they might want to go active or move to an index "that doesn't suffer quite so much" from concentration, and environmental, social and governance issues, said Craig Baker, global chief investment officer in London, on a Feb. 9 virtual investment briefing.

Executives at the £6.8 billion ($9.4 billion) Nationwide Pension Fund, Swindon, England, are looking to take action on ESG concerns. They're set to submit a proposal to trustees this month, proposing to move 25% of the pension fund's passively managed equities portfolio into a passive ESG index. If approved, the transition would begin in April. "The reason we'll transition only in part (at first) is we recognize there are a lot of different ESG indices in the market and a lot are quite nascent and being developed. So let's move part to something that's up and running — it'll probably still have some exposure to things like oil and gas, but lower exposure, and then we'll spend the next 12 to 18 months researching in detail the other indices that take a much more active approach, see how they have developed and (we will) have a better understanding," said Mark Hedges, CIO at the pension fund.

While addressing ESG concerns is a relatively new concept, sources said the issue of company concentration in passive portfolios is not new — it was discussed during the dot-com boom for technology stocks and also ahead of the global financial crisis in terms of financial stocks.

But there is a new intensity to conversations. On the ESG side, it's due to increasing regulatory and client pressure to move to low-carbon portfolios. And on the company concentration side, it's because just five stocks accounted for about 22% of the entire S&P 500 index at the end of 2020 — Facebook Inc., Amazon.com Inc., Apple Inc., Microsoft Corp. and Alphabet Inc., the parent company of Google. Together, these stocks delivered 54% of the entire absolute return of the U.S. stock market last year, sources said, adding that the 22% concentration is also the highest level in history for just five stocks.

The danger, too, is that if history is anything to go by, "something comes along to break" the concentration issue, Mr. Baker said in an interview.

For these huge technology stocks, it could be antitrust regulation, cyclical changes that turn tailwinds into headwinds or unwelcome changes in the tax code. "It may be that a lot of these were 'stay-at-home' stocks that did well, but as we see countries … go back (to physical places of work, that could) lead to a reversal. I'm not saying any of these things are going to happen … (but) do you want 20% of your equities invested in five companies?" Mr. Baker said.

However, being in passive equities did deliver returns last year. The S&P 500 net total return was 17.75% in 2020.

The conversations about concentration concern are leading to "more clients … taking action than I've seen historically," said Mika Malone, Portland, Ore.-based managing principal/consultant at Meketa Investment Group. "To me, the conversation is a little different (from the past) as it has lasted longer and maybe it's time to figure out" how to address concentration and ESG risks, Ms. Malone said, either by identifying "active managers with a chance of performing better … or enhanced indexes."

Aon's Mr. Peach agreed that changes are being made once clients realize the inherent risks underlying some passive equity indexes currently. If clients are looking for low-cost, low-governance equity allocations, "then people default to just a passive market-cap (index), and it does those things quite nicely." However, the consultant is talking to clients about multifactor investing as a way of avoiding the concentration issue in particular.

Passive investors "may not be aware of the concentrations they're running, and it just so happens those concentrations have got bigger in the last 18 months," Mr. Peach said.

The concentration of certain technology stocks is "outrageously large, larger even (than) in the dot-com boom back in the early noughties/late '90s," he said.

It's not just a U.S. equities issue. As of Sept. 30, the MSCI World index returned 5.2% for the year. Apple, Microsoft, Amazon, Facebook and Alphabet, which accounted for about 13% of the index, gained more than 60% on average.

"It was not a broad-based recovery at all — a number of companies were almost tailor-made for the circumstances (of the COVID-19 pandemic and its economic impacts) … and benefited massively," Mr. Peach said.

As such, Aon is talking to clients and helping them to realize that risk is there. "If you want to stay passive in a market-cap index, by all means do, but understand (the risks) and make active decisions to reaffirm that you want to stay in it," he said.

Some clients are "motivated to do something about it," with more than 20 clients moving to multifactor portfolios since the launch of Aon's capability in 2018, and the firm had "a large move last year — AUM that moved last year was the highest we've had," Mr. Peach said.

Aon has also started screening out the worst carbon polluters and banned coal from its multifactor strategies.

While ESG isn't necessarily seen as being on par with other return drivers, reducing exposure vs. an index "certainly is a remover of risk that we don't want to be exposed to," Mr. Peach said.

Regarding avoiding ESG risks, WTW's Mr. Baker said "climate change is probably the one that we talk about most within sustainability, but purely because it's the easiest to model and get your hands around … and it's the one where you see there's a catalyst with the Paris accord and various governments signing up, (as well as) regulation and shareholder pressure on companies."

Plus, it's the most obvious area, he said. "There's no doubt that the public equity markets have got quite a few companies with legacy issues on that basis — high carbon emitters and the like."

It's easier for an active manager to build less carbon-intensive portfolios, he said. "So if you have any beliefs at all that this is going to be a financial factor over the medium to long term, there are good arguments to thinking about whether global market cap is necessarily the right starting point," Mr. Baker said.

But that doesn't mean an immediate jump to active management, he added. Better smart beta may be an option, or some asset owners are looking at low-carbon indexes.

The Nationwide Pension Fund, which after 15 years of poor performance from active management across a number of strategies and paying between 80 basis points and 100 basis points for the service, went passive in 2013 and 2014.

The plan considered a smart beta-type allocation, but the trustees "quite reasonably didn't feel the added complication was appropriate" given the pension fund is frozen and on a slow derisking path, Mr. Hedges said.

But the problem has not gone away "and more recently we have seen growth of (FAAMG) stocks as a percentage of the portfolio — but more importantly a move to focus on ESG factors. In terms of the passive equity portfolio, we realized it does have these risks, it isn't really dealing with ESG on a market-weighted basis, and we need to do something about that," Mr. Hedges said. Additional pressure comes from requirements to align with the Task Force on Climate-related Financial Disclosures standards next year, more awareness around the world and the need to take more action on ESG.

If trustees approve the proposal to shift some assets to an ESG index, moving some now means "at least we're signaling in the right direction, and ahead of TCFD next year. It's very important for us to be good stewards of the assets we hold. We've always challenged our manager, (Legal & General Investment Management), on how they've voted. But clearly we're going to need to move that from not just a governance approach but to an environmental and social perspective as well," he said.

Pension fund executives are also still "mindful of the way equities are … imbalanced" in terms of concentration risk. "A concern of ours is it's an overall position, it does look overheated, and to some extent it is driven by those large stocks at the top," Mr. Hedges added.