by Guido Bolliger
25 May 2023
In Switzerland, the fiduciary duties that apply to pension funds include sufficient return, sufficient liquidity, risk diversification, and investment risk. With the raising importance of “green investing”, pension fund trustees have thus the task of assessing the risk of sustainable investment products.
Regarding risk diversification, liquid sustainable investment products do not add significant diversification benefits within a global strategic asset allocation compared to non-sustainable products. These products are constructed to have a correlation with their non-sustainable counterparts that is close to one. As such, adding them to the allocation won’t decrease the risk of the portfolio.
Tracking-error and volatility risk
Most pension funds consider both volatility and tracking-error when they assess the risk of their investments. Tracking-error (active risk) measures the potential deviations between an investment and its reference index.
Exhibit 1 reports the return and risk statistics for several sustainable indices as well as for their reference index, the MSCI World. It also reports the implied temperature rise (ITR) as well as their weighted average carbon intensity (WACI).
Regarding volatility, we can see that the volatility of sustainable indices is very close to the volatility of the reference index. Historically, investors that switched to sustainable products would not have suffered from higher volatility. Generally, the tracking-error is related to the climate ambitions of the products. Products with higher carbon emission reduction objectives (as measured by the Implied Temperature Rise or the WACI relative to the MSCI World) tend to have a higher tracking-error. This is not surprising as more ambitious climate targets often require higher deviations from the reference index. Note that the higher tracking-error of Climate Change (CTB) and Paris-Aligned indices is compensated by their higher performance. Indeed, their information ratios are higher than the information ratio of the Low Carbon Leaders index.
Exhibit 1: Risk-return and sustainability for carbon reduction products (April 2013 to April 2023)
Source: Bloomberg, MSCI
We saw in one of our recent blogs that the performance of sustainable portfolios was in line with the performance of their reference indices. This document shows that both the total and active risks of sustainable vehicles are in line with their benchmarks. Moreover, the sustainable products with the highest tracking-error have higher information ratios than low tracking-error ones. Investors are thus fairly compensated for the additional active risk that they take. The same is true for other asset classes such as investment grade bonds. Therefore, we see no conflicts between the fiduciary duties of pension funds and “green” investing.