Defining and Meeting Plan Demands for Fossil Fuel Exclusion
The Westwood Managed Investment Solutions team has helped countless institutional investors using a consultative process to develop unique rules-based, outcome-oriented investment solutions for their specific needs and goals. The following case study illustrates how they created a solution for an institutional client with a specific set of challenges.
A large public institutional investor wanted to restrict investments in the fossil fuel industry. Initially, the organization required that no new investments in companies within the industry be added while maintaining existing fossil fuel positions. Eventually, those positions in the sector would need to be liquidated and removed from the portfolio.
Accomplishing this objective would require a number of transactions: initially, restricting the purchase of additional fossil fuel exposure, and then using optimization techniques to allocate exposure to securities that make the portfolio characteristics look as close as possible to the parent index. Altering the index can create increased trading costs as well as impact the risk and return characteristics of the index, potentially challenging the plan’s ability to meet their investment objectives.
There were two main paths to consider: a custom index methodology or an optimized approach, with pros and cons to each method.
Changing the index methodology to simply remove fossil fuels would seemingly be the easiest and cleanest path. If you change both your policy benchmark and index to the ex-fossil fuels variant, then there is less to explain to the board as the performance of the index will be closely aligned with the benchmark. However, this option would create more significant transaction costs as the index constituent active weights would change because of removing fossil fuels and reapplying the factor methodology. The factor exposure would be closely aligned with the original (including fossil fuels) index, but the sector and stock-specific exposures would change. Because the new index would have similar factor exposures and constraints, it should produce similar results over a long time horizon, however, results can differ more materially over the short term. This was demonstrated empirically by rerunning the index without fossil fuels included.
The Managed Investment Solutions (MIS) team also offered an optimized solution, removing fossil fuels and adjusting security weights to bring the portfolio characteristics back in line with the original investment strategy. The optimizer will find substitute securities that behave similarly to the removed fossil fuel companies. By altering fewer stocks in the portfolio, this index management approach reduces transaction costs and helps the client get closer to the original index that includes fossil fuels. However, there would be additional attribution to explain any performance variation versus the policy benchmark with fossil fuels. The search for substitutes to fossil fuel securities may inadvertently reintroduce some fossil fuel risk to satisfy the objective function of making the portfolio as close as possible to the original multi-factor index that included fossil fuels.
The client ultimately chose the optimization approach. Structuring the portfolio in this way helped to achieve the goal of removing fossil fuel companies, reducing transaction costs, and making the portfolio characteristics look as close as possible to the original index exposure. The team was able to model for plan administrators how the portfolio would likely be affected by different circumstances, such as oil price shocks.
By implementing the proposed solution, the client would no longer own the designated fossil fuel stocks, in alignment with what was mandated by the governing body. Second, the portfolio would still target the risk characteristics of the original factor-based universe with fossil fuels. The proposed solution would also reduce transaction costs related to eliminating existing fossil fuel positions and reweighting the entire portfolio. Finally, the new portfolio can evolve as the client’s needs change. Since the future is uncertain, having flexibility was important to them. They can adjust their risk exposure higher or lower while controlling for transaction costs. Finally, they would also be provided the necessary attribution and scenario analysis to explain any deviations to their board.
The implementation process began with a discussion about building parameters for the portfolio restriction. In this case, it meant more directly defining which companies were considered to be in the “fossil fuel” universe, as this can be open to interpretation — for example, retailer Walmart, in the Consumer Staples sector, may be considered a “fossil fuel” company by some people, because they have a significant business selling retail gasoline. The MIS team used a consultative approach, which included working with plan consultants and helping all parties involved understand and agree to a framework to create a process to identify companies that should be excluded based on the fossil fuel requirement. The team didn’t simply recommend a solution, but rather laid out options for the plan that helped administrators and consultants understand the benefits and drawbacks of different approaches.
After agreeing on an approach and an implementation process, the team set about implementing the optimization approach. Plan administrators were able to meet the stated objective of eliminating fossil fuel companies from the multi-factor index. More importantly, it was able to do so while still maintaining a portfolio with similar risk and return characteristics to the previous asset mix that included fossil fuels. With this approach, developed in consultation with the MIS team, both plan administrators and participants were satisfied with an outcome that met the needs of their investment objectives.
Investment solutions that work for you
Your needs and objectives are specific. You deserve an investment solution that is best suited to accomplish your goals. The experienced professionals of Westwood’s MIS team take the time to work with you, understand the challenges you face, and design a customized approach that specifically aligns with your unique goals, beliefs and objectives. Our MIS team can choose the tools and data sources required to help you achieve your desired outcomes.