Sustainable investments need not be limited to the long term. Money market funds (MMFs) can also embrace environmental, social and governance (ESG) factors and help investors achieve sustainability across their holdings.
Embracing ESG to reduce risk and potentially boost returns has become increasingly routine for bond and equity funds.
However, investors rarely consider extending such an approach to short-term investments such as MMFs.
At first glance that seems to make sense. The risks and opportunities associated with trends such as climate change are, by nature, long term. Which means it is difficult to see their relevance for investments with maturities of 13 months or less.
But dig deeper and the importance of ESG in this critical area of the financial market becomes clear.
It’s worth considering the function MMFs play.
Designed to be safe, cash-like investments, MMFs seek to avoid risk. While financial risks are the biggest risks to be identified in money markets, non-financial risks are also a part of the credit risk analysis.
History shows, for instance, that governance failings among issuers of short-term securities have caused severe losses for MMFs whose risk controls fell short.
But governance is not the only non-financial risk money market funds confront. Credit ratings agencies are increasingly incorporating environmental and social considerations explicitly into their analysis, and it has been shown that companies with better ESG characteristics tend to have better credit ratings
For our part, we have, over time, actively excluded a number of financial companies from our universe due to governance concerns. Several of them were subsequently downgraded by rating agencies.
Adhering to ESG principles in money markets not only mitigates risk – it can also help in efforts to bring about positive change.
Research shows that, in general, firms that focus on sustainability and environmental issues benefit from a lower cost of capital than their peers. By focusing on companies with strong ESG credentials and avoiding those with weak ones, money market funds can also play their part in this effort, and make their mark
Increasingly, asset owners take the same view. A growing number understand the importance of applying ESG principles across their entire portfolio, including shorter-term investments, which they recognise play a critical role in funding the financial system.
With ESG-aligned issuers making for safer securities, holders of sustainably managed MMFs do not have to compromise on the yield, diversification and liquidity of their portfolios. In other words, MMFs can make their contribution to building a sustainable economy without jeopardising their fundamental characteristics.
Of course, there are limitations. For now, at least, money markets are not a particularly rich hunting ground for investments that directly promote sustainability or carry the ESG label, such as green or social bonds.
But that is changing.
Issuance of ESG-linked commercial paper is slowly rising, and there are more opportunities appearing in the secondary market, too, as early-mover green bonds approach maturity and thus enter the time horizon of money market investors. Their number will only grow.
Overall, we see ESG as a natural complement to our conservative investment process.
While we exclude investments that fall short of our ESG criteria and give an allocation premium to well-rated issuers, we retain the focus on liquidity and diversification that has always distinguished our money market franchise.
For all these reasons, short-term money market strategies have recently been classified ‘Article 8’ under the European Sustainable Finance Disclosure Regulation (SFDR) – a rating awarded to investments that include ESG factors in their investment decision-making process and promote environmental and social characteristics.
So, what does that mean in practice? Our approach is twofold.
Firstly, we have designed a negative screening plan. Our funds exclude a number of sectors from the investment universe, including tobacco, oil and gas, nuclear power generation, thermal coal, pesticides, gambling and weapons. We also exclude all issuers that breach the UN Global Compact Principles.
Secondly, our investment process includes a positive tilt towards issues with strong ESG characteristics. This means that besides excluding companies with the worst Sustainalytics scores (ones with a controversy score of 5), we give an allocation premium to companies with negligible, low and medium risk.
Keeping our conservative approach in mind, expressed by strict guidelines on diversification, our maximum allocation per issuer can be increased by 1% based on their Sustainalytics rating and the credit analyst’s opinion.
Implementation was simplified by the fact that asset-backed securities – where sustainability characteristics of the underlying assets are notoriously hard to monitor – were never part of our investment universe as we judged them too risky for what is essentially a conservative and risk-averse product.
Although we have had to make some adjustments to the portfolio to accommodate our ESG focus (such as disinvesting from some tobacco and oil companies), these have been very marginal from a performance perspective.
There is still a sufficiently diverse universe to enable us to maintain high levels of liquidity and generate yield.
And, as we don’t have any composite benchmark (instead comparing performance with cash or a cash-equivalent index), there are no concerns about tracking errors, as there can be for other types of strategies.
At Pictet Asset Management, we take a responsible approach to investment management, and aligning our short-term MMFs with ESG principles is a natural part of that.
In our view, ESG goes beyond a box-ticking exercise; it is very much an investment philosophy – and one that can be embraced successfully, even on a short time horizon.
David Gorgone is client portfolio manager at Pictet Asset Management
