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Custom Equity Portfolios Disrupt Pension Funds’ ESG, Index Investing

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New paper predicts the rise of custom equity portfolios for institutional investors

Managing customised equity portfolios in-house is one of the biggest trends to develop over the next few years among institutional investors, according to a new report from quant technologies provider SigTech.

In his whitepaper ‘How custom equity portfolios are disrupting pension funds’ ESG and index investing,’ Daniel Leveau, who manages SigTech’s strategic initiatives for institutional investors, argues that the combination of digitising the value chain of the investment management industry, ESG taking centre stage in the investment process and investors’ need to customise their equity investments, has created new opportunities for the industry. 

Daniel Leveau, SigTech

“Five years ago, the idea of creating and executing your own index strategies in-house would have been a daunting task. Today, it is 100% achievable. Custom equity portfolios allow institutional investors to define the investable universe and tailor their investment strategy to incorporate specific ESG policies and to directly hold individual securities”, comments Leveau. 

“By applying the concept of alternative indexing methods, investors can gain exposure to various risk factors that are optimal for them. One might want global equity exposure with larger downside risk, another a larger bias to small caps, whereas a third investor might desire a stable income from dividend payments. The same goes for ESG. No two ESG policies are alike. By owning the securities directly, investors can decide to what degree they want to be an active owner through voting and direct engagement.

“Investing is not about searching for an existing product that offers the best possible fit to the investor’s needs. It is about creating a product that 100% fulfils the investor’s requirements.”

Below we look in more detail at how ESG and indexing can be combined effectively and how the digitisation of the investment management sector now enables transparent, customised solutions that are created in direct alignment with the asset owner’s requirements.

ESG and indexing in combination

How does combining ESG and indexing work in practice? Today, investment products are mostly offered in “one size fits all” versions in the form of mutual funds or ETFs. An increasing number of index products that implement ESG policies have entered the market recently, but it is unlikely that these are fully aligned with an individual investor’s specific ESG policy. Aside from a lack of alignment, investors struggle with ESG rating agencies which often assign wildly divergent ESG scores to companies. 

The divergence is attributed to how the rating agencies define and measure ESG performance. Many of the criteria are hard to measure and assigning a rating for a specific criteria is often not as precise as using input from a firm’s financial statement. This ambiguity around ESG performance makes it hard to form a universal standard for ESG ratings.

Apart from this suboptimal situation, investing in a pooled investment vehicle – as opposed to owning the individual securities directly – such as an index fund or an ETF, makes it even more difficult for an investor to become an active owner. A pooled investment vehicle only gives the investor indirect ownership of a security. Investors don’t have the right to vote at a company’s annual meeting and it is more difficult to actively engage with these companies to constitute change. Lately, large institutional investors have increasingly come under fire for being anonymous owners and not taking full responsibility over their investments. 

Instead, Investors would be better off tailoring equity investments according to their desired risk factor exposure and incorporating their unique ESG policy. “One-size-fits-all” products are not the solution, investors need to embrace customisation and direct ownership of securities.

Digitisation

The commoditisation of investment strategies (e.g. through rules-based products such as index and smart beta products) is driven by technological advancements and has resulted in fee pressure for asset management products. Gradually it is also impacting the distribution process. Instead of offering pre-packaged products, fully transparent customised solutions are created in direct alignment with client’s requirements. To enable investors to profit not only from efficiency gains, but also from customisation, scalable turnkey solutions are now offered by service providers.

Rethinking equity portfolios

The investment management industry is undergoing tremendous change. Indexing and ESG are reshaping investor portfolios, whereas digitisation is impacting the industry’s entire value chain. Investors no longer need to look for an existing investment vehicle that is most closely aligned to their needs. They can now create a bespoke product that meets their requirements fully.  Custom equity portfolios are expected to become one of the biggest growth areas in asset management and are one of the industry’s most exciting new developments.