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What does low-carbon transition mean for passive?

The shift towards a low-carbon economy will be faster than many investors expect.

This is the view of Kepos Capital founding partner Bob Litterman who, in an interview with Robeco, outlined how this swift transition could impact passive investment products and quant models. 

Mission alignment

Firstly, how will passive investment products evolve in this changing world?

“I think the move toward passive management we’ve seen over the past decade makes a lot of sense. But, currently, it’s hard to say what a passive portfolio would look like, once aligned with a rapid transition. Because it is not only about removing fossil fuels from a passive portfolio,” Litterman says.

To illustrate his point, he refers to a situation seven years ago, when he was head of the investment committee at the World Wildlife Fund.

“We were thinking about how to align our portfolio with our mission. We didn’t want to have stranded assets, or coal and oil sands in our portfolio. So, we thought about divestment. But our advisers warned us that this would require us to get rid of many actively managed funds and ultimately cost us an arm and a leg.

“So, they gave us a cost-effective way to do it, which was an overlay, a swap actually – we called it a stranded asset total return swap. We entered into a contract with a bank. We paid them the total return on this basket of stranded assets, and they paid us the total return on the S&P 500 Index. This was a very simple, inexpensive way to get rid of those undesirable assets.”

Litterman adds: “Well, that instrument had an 18% annual return. We did not expect that, but it turned out so. My point being that the revaluation of assets started long ago. So, would a passive portfolio excluding fossil fuels outperform going forward? I don’t know, because those assets are now so much cheaper. Today, it’s more complicated than basic exclusions. It is more about selecting the right companies.”

Government and covid

Caspar Snijders, equities portfolio manager at Actiam, believes the ‘rapid transition’ is gaining visibility due to the impacts of the covid crisis and the policy responses from governments. He argues that the recovery plans from the EU as well as the US have (partly) included the climate transition within their packages. So the rapid transition indeed shows momentum.

He suggests the impact on passive investment products will depend on the specific ‘passive’ product.

“Passive investment products that track broad benchmarks will be impacted (on the downside) of stranded assets but also by increased CO2 prices. But since the EU taxonomy, benchmark providers have been developing benchmarks that adhere to the EU standards taking into consideration impacts of climate change on specific companies and their activities.”

Snijders stresses that exclusions solely based on data do not tackle the intricacies of the impact of climate change (both physically as well as, for instance, policy impacts). However, with a strong fundamental view on companies that most likely won’t be able to adapt within a rapid transition pathway, exclusions are still a strong policy tool; where, within this context, material climate risks can be mitigated.

Taking it a step further, he says that in addition to the climate change pathway being taken into account, a more fundamental holistic view should be implemented as not only climate change will have material impacts.

“Deforestation or scarcity of water can impact supply chains of companies more rapidly than investors might expect”, he says.

Do quant models have a future?

If we accept the premise that climate change will radically transform the economy, aren’t quant models – which tend to rely on past statistical data – at risk of becoming obsolete?

Referring to his earlier comments, Snijders adds: “Quant models can still be implemented, but passive products will have more pronounced ESG look and feel to them once aligned with a rapid transition.”

Fannie Wurtz, head of Amundi ETF, indexing & smart beta also takes the view that passive management is fully compatible with ESG.

“Climate positive indices focus on the energy transition topic with measurable and tangible impact and the new EU climate benchmarks (CTB/PAB) designed to align investors’ portfolios with the Paris Agreement will enable the provision of clear and transparent standards.”

She adds: “These climate benchmarks recognise the central role of index management in the transition towards low carbon economy.”

Litterman believes there has to be a slight shift in perspective. “If you ask me whether addressing climate change has more to do with fundamental investing than quant investing as we know them today, the answer is yes. It will have more to do with fundamental. That said, as quants, we can also think about the impact of the rapid transition and try to take advantage of it.”

“Think about the consequences for oil or the automotive industry, for example. Think about stranded assets. Think about the consequences for valuations. Investors are going to have to monitor all these things, and they will need metrics and statistical tools for that. And if that’s how you think about quant investing, then it can remain relevant.”

Litterman talks about creating a factor that would reflect expectations of future carbon pricing. “Then you could screen every asset and assess its loading on that factor. And that could help you to identify investment opportunities. Quants, you know, always try to be forward looking, even if the data they use is always historical data.”