Holly Black: Welcome to the Morningstar Series "Ask the Expert". I'm Holly Black with me is David Barron. He's Head of Index Equity at L&G. Hello.
David Barron: Hello, how you doing?
Black: I'm good. So, we're here today to talk about how index investing and ESG work together. So, what are some of the ways you can express your view through an index fund?
Barron: Sure, I think there's kind of three main approaches that people take. The first and I would call it, the traditional approach is just kind of a divestment consideration. So just removing stocks that maybe scored bad on ESG from the portfolio and reweighting the rest. Then you kind of see a more integrated approach using you know, maybe an optimization, trying to target a certain ESG objective. And the last I would say, is kind of a tilted approach to just, you know, allocate to some companies who score well and take some, some away from companies who don't, but still maintain exposure. So, you can engage and incentivise change.
Black: But I would have thought – so in an index fund, you're just tracking a chosen market. So, do you have the flexibility to divest from companies?
Barron: Yeah. So that's, that's a great question. So, some of this, you can build into the index strategy itself. And then in some instances, there is an opportunity to take a little bit of tracking error in the fund, if there's a, really potentially bad actor, that's not engaging on how you'd like them to engage. So, one of the things that we do is, a set of targeted engagement strategies with some high profile companies. And if they don't meet some minimum criteria, we can remove them from the fund, and then, from a fund management perspective, kind of reweight the fund to make sure that we're still tracking that that mainstream index that we're targeting,
Black: And is divestment a last resort for you.?
Barron: Absolutely. I mean, last resort, I think, you know, the focus is always on the engagement story and that there's, there's a lot of that, that that we can do. You know, that's why we think one of the one of the logical ways to build an ESG index is to hold majority of companies, so you can still have that, that kind of voice. So yeah, engage, engage. And then if there is no response, you know, a big stick can be that divestment.
Black: So how often does that come up that you would do that?
Barron: In one set of our funds, we are calling it the Future World Range, it's an annual process. So you know, set some minimum criteria, engage with the companies, if they don't adhere to some of these, fairly straightforward things that we're trying to incentivise them to change, then we'd divest from kind of the whole series. And that's a pretty powerful stick, we think. We also have the opportunity to vote against share for the rest of the assets that we hold in kind of standard index products, where we're not going to take that tracking error.
Black: But isn’t it hard to get business to change if you don't invest in it. If you don't hold its shares?
Barron: Absolutely. I think that's why it is a last resort. I do think you know, when you come up with that, that divestment and then potentially some naming and faming, and naming and shaming with a subset of companies, you do get some pretty good responses. So actually, since divesting in this Future World Range, two companies who are on the bad list effectively have gotten back into the the index products because they've righted their ship. So, we're still seeing engagement after divestment, partially because we hold them, in other funds, and partially because they want to get back into this fund range.
Black: And how much does that change the index? So, if I want to track the FTSE or the S&P, and you're divesting? Am I still just getting the FTSE's return?
Barron: Yeah, I think, the way we set it up is, clients, you know it's always about client solutions, delivering what the client wants. So, we do have a set of funds that don't have any of this divestment in them, right. And you can be part of that, that fund range and guarantee that you're going to track you know, to the best of our abilities. We're very open and honest about the funds that do incorporate the divestment. And we have a max tracking error tolerance. So, at the end of the day, even in these funds that do incorporate divestment, I want to deliver the index return for these clients. And so the amount of tracking error that we take is fairly limited. And it's all about, redistribution of that capital and trying to minimise tracking error.
Black: Well, thank you so much for your time.
Barron: Absolutely. Thank you,
Black: And thanks for joining us.
