The major risk that isn’t priced into passive funds

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Many passive investors may be left holding companies that face major downside due to climate risks and other ESG risks, according to fund managers.

Whether it is in the form of extreme weather events or the transition to a lower carbon economy, climate change risks are a growing area of concern for managers.

Climate change is “the paradigm shift of our century,” according to Jennifer Wu, global head of sustainable investing at JP Morgan Asset Management, which she said brings risk to society, but also an unprecedented opportunity.

“Differences are emerging, between the potential winners and losers, and these are only just starting to get priced in by the market,” she said.

“By acting early, before climate risks and opportunities are fully priced in, investors can capture potentially significant returns as prices continue to adjust.”

Indeed, Abbie Llewellyn-Waters, manager of the Jupiter Global Sustainable Equities fund, believes that as decarbonisation gains pace, “investors are at risk of an inevitable and sharp correction in asset prices”.

She said: “The climate crisis is no longer just an issue for future generations to worry about; it is the defining challenge for our world today, and yet climate-related financial risk has long been mispriced within investment markets.

“Due to the magnitude of risk that climate change presents to the global economy and human society, we believe that it is a financial imperative for investors to evaluate climate risk in their portfolios.”

Nevertheless, while the range of ESG (environmental, social & governance) options for passive investors continues to grow, such as the recently launched MSCI Climate Indexes, most passive investors are more exposed to climate risk than they realise.

Christopher Rossbach, manager of the J. Stern & Co. World Stars Global Equity fund, said: “I think there’s tremendous ESG risk embedded in some of the broader indices.

“Market cap-weighted indices like the S&P 500 and the funds that track them do include many companies that are more sustainable, are more forward-looking and are getting bigger and bigger, but they also include other ones that are less sustainable, more backward-looking, have greater ESG issues and are getting smaller and smaller.”

Whilst the market has rewarded the companies that are more forward-looking and punished those that are more backward-looking, he believes “there’s a lot more punishment to come”.

He said: “I think one of the elephants in the room is, as the world is moving towards investing more sustainably and taking into account the UN Sustainable Development Goals, then how can you invest in indices?

 “You’ve been told for the last 25 years, buy indices and ETFs because it’s cheaper and nobody ever outperforms it, but you are taking on climate risk and other ESG risks by investing in those companies.”

California utility firm PG&E is widely considered the first S&P 500 firm that has declared bankruptcy because of extreme wildfires that many argued were a result of global warming and climate change.

Rossbach said: “As the saying goes, ‘only when the tide goes out do you discover who’s been swimming naked’ with PG&E, the tide went out, and they were swimming somewhat naked.”

He added: “I think that climate change is real and it has first, second and third order impacts that are not fully priced in.

“We’re in a world where it’s about intellectual capital, not physical capital, and where it’s about opex [operating expenditure] not capex, so it’s all about the future cash flows and growth, not so much about returns on some kind of past invested capital.

“Car companies, aircraft businesses, and fossil fuel companies, these are all examples of companies that have huge amounts of capital that is close to being stranded by disruption, by technological change, and by climate change.”

However, climate risk is not just limited to the obvious carbon-intensive culprits. Rossbach pointed out that even the most forward-looking corporations such as Facebook and Google, who have committed to net zero greenhouse gas emissions and 100 per cent renewable energy, are still at climate risk if extreme weather events were to hit their data centres, for example.

 

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