ESG in LDI and derivatives

Responsible investing is rightly attracting a good amount of investor attention at the moment. However, many investors assume that there is little you can do regarding environmental, social, and governance (ESG) approaches within derivative or liability-driven investing (LDI) mandates. This is far from the case.

Those who know of my reusable coffee cup collection, or who have read some of my other blogs like “Penguins in Somalia”, will already know about my equal passion for LDI and derivatives, and will therefore not be surprised to find how passionate I am about this. There is in fact much that you can do to integrate ESG into LDI and derivatives, but it’s clear that up until now, those of us in these investment areas haven’t spent enough time talking about it!

Setting the record straight

Within LDI and other derivative mandates at LGIM, ESG is prioritised as an essential component and can be integrated through two primary routes:

1) Counterparty review: analysing ESG-related criteria in the assessment of counterparties; and

2) Governance: engaging with regulators, governments and other industry participants to address long-term structural issues.

Counterparty review

ESG can be incorporated into counterparty reviews in many different ways. However, personally I believe (and fortunately for me, we at LGIM believe) that ESG credentials should be part of the fundamental review of each counterparty’s creditworthiness, so that when we come to decide upon appropriate derivative counterparties, ESG has already been captured.

As such, the LGIM process combines a quantitative input, using external data providers, with qualitative inputs drawn from our active engagement through more than 3,000 management meetings and ESG engagements each year. The results are then implemented via our credit and equity analysts, Investment Stewardship team, and portfolio managers. Our proprietary tool evaluates 64 sector-specific ESG factors, normalised for each sector, and adjusts the weightings according to relevance and materiality for each sector. This ESG tool is used by our credit analysts and, combined with other business and financial risks, feeds into our review of each counterparty with whom we trade derivatives.

Governance

We believe that active engagement in the development and evolution of the LDI and derivative landscape provides a real opportunity to add value for clients and to change the industry for the better. We take a long-term perspective and focus on addressing key themes and emerging governance and sustainability issues that we think could impact the value of our clients’ investments.

As such, LGIM has in my view led the market on long-term strategic issues such as the introduction of central clearing, the LIBOR transition, and recognising the pricing issues with bilateral RPI swaps (while avoiding the negative cost impact experienced by some of our peers’ pooled funds). We believe that staying ahead of regulatory changes and adopting best practice early is important because market conditions typically deteriorate as deadlines for adoption approach, or as adoption of best practice becomes more widespread. We monitor these situations carefully and proactively to aim to save money for our clients and reduce risk.

As an example, we believed bilateral trading resulted in too many risks for our clients, while also creating complex governance issues. We therefore began clearing our pooled fund interest rate swaps in 2012, making us the first LDI manager to do so, and broadened this out to include inflation swaps in 2015, making us the first on the buy side to do so. This provided a structural long-term solution for minimising counterparty risk. Of course, counterparty risk is still present on cleared swaps or repos, but we believe it is more manageable than on bilateral trades.

Industry engagement

We also strive to improve standards for the industry as a whole. As part of this, we participate in a number of industry bodies to formulate and provide guidance on best practice in LDI. These include working groups with the Institute of Actuaries, alongside various sterling risk-free rate subgroups, the money market code sub-committee, and the FMSB group (Fixed Income Currencies and Commodities Markets Standard Board) on trading benchmark close (as the main buy-side contributor), among others.

As markets continue to evolve and explore new technologies and new limits, we think it is more important than ever to continue to work with others in the industry to improve standards for all market participants. We believe that ESG has as important a role to play in LDI and derivative portfolios as it does in other asset classes. Through our engagement activities, portfolio management and operational decisions, we believe we can continue to pave the way towards a better future for our clients.