Beyond the black box: how index investors can support the net zero transition

Index funds have their fair share of prominent proponents. Warren Buffet, the Berkshire Hathaway boss, is amongst them. In 2007, the oracle of Omaha challenged a hedge fund manager to a decade long outperformance duel. While the manager invested in several funds-of-funds, Buffet simply placed his bets on an index fund.

For nine of the ten years that followed, Buffet’s index fund outperformed the manager.

Buffet’s embrace of the logic of an index fund – is increasingly reflective of asset owners with net zero targets. Some 44% of the world’s long-term assets and 60% of Europe’s climate funds are parked in index funds and ETFs.

New research from the Institutional Investors Group on Climate Change (IIGCC) – an investor coalition – highlights the challenges index investors face in decarbonising their portfolios and identifies a way forward.

The appeal of the index

The appeal of climate indices, the IIGCC notes, has widened amongst asset owners. For starters, indices are being used as policy benchmarks to guide asset allocation. Additionally, climate indices are supporting the design of climate-linked financial products.

Lower cost – the most commonly cited feature by index investment aficionados – is also fuelling the appeal. There is also a case to be made on the climate performance front.

Take for instance, the case of Ilmarinen – Finland’s largest provider of private pensions insurance – an example that IIGCC’s research cites.

In early 2023, Ilmarinen took on the MSCI climate action index as a performance benchmark. Currently, nearly €33bn of Ilmarinen’s listed equity assets are benchmarked against this index.

Explaining the decision senior portfolio manager Juha Venäläinen noted at the time: “We have been involved in developing an index that aims to reduce the risks to the value of investments caused by climate change and to benefit from the opportunities arising from the fight against climate change”.

The Finnish asset owner was aiming to reduce carbon intensity of listed equity holdings by 50% by 2030. In April this year, Ilmarinen announced it had exceeded its target by 12% – five years ahead of schedule.

Phoenix Group, the UK’s largest savings and retirement business has a similar tale to tell. In June 2024, the group launched a ‘climate aware’ index series alongside FTSE Russell. The decision was guided by reasons similar to Ilmarinen – better climate risk management and a quest for higher returns.

Barriers to target

There are, however, limitations to such approaches. IIGCC’s paper notes several challenges that index investors are facing.

First, a climate-tilted index incentivises reducing financed emissions as opposed to financing reduced emissions. In other words, real world impact is harder to evaluate. In effect, if climate indices push portfolios away from hard-to-abate sectors, emerging economies or both – the strategy’s real world impact will come under the scanner.

Additionally, given that index strategies draw lower fees from a broad client base and passive management – effective corporate engagement becomes a complex task.

There is also the risk of tracking errors given that climate-driven long term shifts have lower explanatory prowess over short term fluctuations. Then, there is the alignment question – how do investors measure an index’s transition alignment?

Way forward

Noting these challenges and their centrality to the index approach – the IIGCC makes a few recommendations. Many of which relate to the Net Zero Investment Framework.

For one, NZIF uses a mix of backward, current and forward-looking criteria to assess alignment. Most, have a reasonable degree of data coverage.

“Within NZIF, the lack of data is not a reason to allocate away from companies or sectors in transition. Instead, engagement and the use of non-core additional criteria may be utilised to strengthen assessment and alignment”, the IIGCC paper reads.

Next, the IIGCC recommends working with index providers to increase not only visibility but also refine index alignment with objectives such as coal phase outs in emerging economies.

Index construction, the research highlights, is where significant gains can be made. 

Fundamentally, the IIGCC research concludes, it comes down to “defining clear investment objectives, selecting appropriate climate data metrics, and ensuring consistency with financial constraints such as liquidity and diversification”.

The engagement question

On engagement, the options are limited. However, the IIGCC notes, index investing could play a symbiotic role with an investor’s broader stewardship efforts. This depends on whether capital flows under the index rules favour companies with a positive track record on emissions reduction.

The IIGCC research highlights the approach adopted by Japan’s Government Pension Investment Fund (GPIF).

GPIF pays its managers a separate fee for engagement. When the Japanese asset owner most recently evaluated the effectiveness of the resulting index fund engagement – the results were promising. Index fund engagement, although at a cost, was associated with improved financial and climate performance by companies.

GPIF’s conclusion - that index design and institutional engagement could work well together – offers an innovative approach to a persistent problem.

Index investing is quickly becoming a notable and indispensable component of net zero asset allocation, the IIGCC research shows. Importantly, the rise of climate indices and their popularity amongst asset owners has crucial consequences for risk, return and real world emissions reduction.

Yet, as the IIGCC highlights – critical challenges persist. Left unattended, they risk shifting focus away from real-world emissions reduction.

In that context, IIGCC’s research leaves readers with a warning: the low-cost appeal of climate index strategies could come at a high price. Investors beware.