The wave of ethical funds and product launches has not escaped the attention of iFunds Asset Management but rather than just unveil a product for fear of missing out, the group waited until there was enough demand from its client base before joining the party.
The move was a simple one, according to investment manager Chris Baynes (pictured). “We were asked whether we had an ethical range and we didn’t, so we put a product together for one of our advisers. It’s a growing area, so we were keen to plug a gap in our offering.”
The product went on to become a full-on range that the firm launched to the market in November 2018. The range contains four portfolios – cautious, balanced, growth and aggressive – which are benchmarked against Asset Risk Consultants (ARC) indices and range from 76 to 85 basis points.
It uses exchange-traded funds (ETFs) and trackers to gain access to equity and government bond markets globally and the companies invested in meet socially responsible investing (SRI) criteria.
Baynes says another driver for the launch was the Financial Conduct Authority’s increasing focus on this area, including the publication of a discussion paper on climate change and green finance, as well as encouraging advisers to keep up with the changing trends in ethical investment.
iFunds as a house uses predominantly passive products as building blocks, both to keep a lid on costs and because the team believes passive outperforms active over the long term when costs are taken into account.
It also likes the fact that with passive the ethical screening process is built into the index, meaning there is no fund manager subjectivity or emotion applied to the method.
He says: “What’s ethical to one person might not be to someone else. Also, a fund manager might be swayed by the fact that one stock has performed very well for them, therefore they’re loath to sell it, even though some news might have come out that’s made them question the company’s ethical status.
“With passive the rules are the rules. If something falls foul of these rules, it gets kicked out.”
But it is not a purely passive range. The portfolios also have an active overlay based on an objective and quantitative process which assesses the current condition of the market for bonds and equities.
If the market is in a positive upward trend then the portfolio will hold its maximum permitted weight; if it is in a negative downward trend, exposure is significantly reduced and cash is increased.
“We apply risk management using comp-based processes to determine whether equities or bonds are at risk of negatively trending. If they’re negatively trending, we reduce exposure to that asset and increase cash.”
Lay of the land
So, what is the overlay currently telling him? “It’s saying global equity is risk-off, that we’re negative trend, and bonds are risk-on or positive.”
Given the return of volatility to markets, the cash position is 18% in the cautious portfolio and 40% in the aggressive portfolio. This has been the case since October when the group’s overlay decided to go risk-off global equities after determining they were in a downward trend.
What the firm does with the cash holding varies from platform to platform, according to Baynes. It will either sit in cash-like instruments or in pure cash. “We don’t strictly put the cash to work,” he says. “It’s there as an asset in its own right to protect against adverse drawdowns and volatility.”
This is particularly important from a pensions drawdown perspective, he adds.
Given the firm’s negative stance on global equity, Baynes says it is difficult to see the cash position reduce any time soon even if it means missing out on significant upside.
“These portfolios have obviously missed out on a bit of that bounce because they’re in cash but that is something we stress at the outset. The trade-off is that we offered protection from some of the drawdown in October and December.”
Baynes says that given the proliferation of passive ethical products on the market, it was not difficult to find ETFs and trackers for the portfolios, although he feels there could be more.
“I have no doubt there will be more as the demand rises,” he says. The issue is the lack of currency-hedged options, especially in the SRI bond space.
Cost comes into the decision, as does the underlying benchmark and liquidity spread. “There are funds that are cheap but they may have larger spreads because they are small, or they may not be quite as liquid, or may not track the underlying index as well as a Vanguard or iShares fund that might cost marginally more.”
The bond exposure is all from UK, US, Japan and Europe developed market government bonds. All exposure is hedged. “If you don’t hedge currency, you’re basically just buying the underlying currency rather than the bond.”
Screen play
Baynes says there are important differences between environmental, social and corporate governance (ESG) and SRI investing.
He explains: “For example, if you take the MSCI World Index there are 2,800 companies and if the ESG screen is applied there are about 2,500. That’s only about 12% of the companies that have been screened out. When you move down to the SRI World Index, there are 400-odd companies. So you’ve screened out 80% of the world’s companies.
“People tend to slap ESG in front of things and think they’re ethical, but actually there’s a significant difference between ESG and SRI.”
iFunds likes the SRI approach because it offers an additional screen. Baynes notes that in the MSCI World Index there are only two companies in the top 15 that are present in the screened version: Microsoft and Intel. The likes of Apple, Amazon, Facebook, Alphabet (Google) would all be filtered out by an SRI screen.
Does screening out certain names influence performance? This is something a lot of advisers worry about, says Baynes.
“The research we’ve done shows that SRI versions of the funds have performed in line with the ESG and the non-screened versions and actually outperform them at times.”
In fact, SRI portfolios have performed well in recent months given the absence of the likes of Apple, Facebook, Google etc, which sold off in Q4.
In terms of costs, Baynes says an SRI fund is 10 basis points more than a straight passive approach but, in comparison to the active space, he does not feel this is much to pay. He mentions the iShares MSCI World, which has a standard OCF of 20 basis points compared with 30 basis points for the SRI version. “The cost differences aren’t that big,” he adds.
Some cynics would say no fund or ETF can be truly ethical if it invests in government bonds because these fund governments that might invest in weapons and defence, for example. What does Baynes make of this argument?
“All companies pay corporation tax, which goes to governments. Those governments then spend that money on stuff people might find questionable.
“If you opt to go down the SRI bonds route because you don’t like what governments do with the taxes they receive, you’ll end up with purely corporate bond exposure.”
It’s a dilemma, says Baynes, but it is important when running ethical strategies to be open and honest about the holdings. Also, iFunds only invests in developed markets, which in theory should reduce the risk.
“We’re not trying to hide anything. We are saying we accept that certain governments might do questionable things but, overall, we believe governments are a force for good for the majority of the time. If more products become available, it’s something we might look to switch to if there’s demand for it.”
Judgement call
In order to offer clients transparency, iFunds publishes a list of all the underlying equity holdings and how much of the portfolio is allocated to them. As would be expected from an ethical fund, the portfolios have no exposure to weapons manufacturers, gambling, pornography etc.
Baynes says the index methodology is set in stone but clients can then look at the holdings list and if there is a questionable company they can see what their allocation to it is and make a judgement call.
“They might say, ‘Well, I don’t like holding company x, but actually company x only makes up 0.2% of my portfolio, therefore I am prepared to accept that’.”
