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ESG in short-term money market funds

October 2021
Marketing Material

ESG: the money market approach

Sustainable investment need not be limited to the long term. Money market funds can also embrace ESG and help investors achieve sustainability across their holdings.

Embracing environmental, social and governance (ESG) factors to reduce risk and potentially boost returns has become increasingly routine for bond and equity funds. However, investors rarely consider extending such an approach to short-term investments such as money market funds. At first glance that seems to make sense. The risks and opportunities associated with trends, like climate change are, by nature, long term. Which means it is difficult to see their relevance for investments with maturities of 13 months or less. But dig deeper and the importance of ESG in this critical area of the financial market becomes clear.

First, consider the function money market funds play.

Designed to be safe, cash-like investments, money market funds seek to avoid risk. While financial risks are the biggest risks to be identified in money markets, non-financial risks are also a part of the credit risk analysis. History shows, for instance, that governance failings among issuers of short-term securities have caused severe losses for money market funds whose risk controls fell short. But governance is not the only non-financial risk money market funds confront. Credit ratings agencies are increasingly incorporating environmental and social considerations explicitly into their analysis, and it has been shown that companies with better ESG characteristics tend to have better credit ratings.1 For our part, we have, over time, actively excluded a number of financial companies from our universe due to governance concerns. Several of them were subsequently downgraded by ratings agencies.

 
Fig. 1 - Avoiding controversy
Sustainalytics ESG ratings - controversy scores for Pictet-Short Term Money Market EUR strategy, % of portfolio
Controversy scores.png
Source: Sustainalytics, Pictet Asset Management. Data as at 30.09.2021.

Adhering to ESG principles in money markets not only mitigates risk. It can also help in efforts to bring about positive change.

Research shows that, in general, firms that focus on sustainability and environmental issues benefit from a lower cost of capital than their peers.2 By focusing on companies with strong ESG credentials and avoiding those with weak ones, money market funds can also play their part in this effort, and make their mark.

Increasingly, asset owners take the same view. A growing number understand the importance in applying ESG principles across their entire portfolio, including shorter term investments which they recognise play a critical role in funding the financial system.  

With ESG-aligned issuers making for safer securities, holders of sustainably-managed money market funds do not have to comprise on the yield, diversification and liquidity of their portfolios. In other words, money market funds can make their contribution to building a sustainable economy without jeopardising their fundamental characteristics. 

Of course, there are limitations. For now, at least, money markets are not a particularly rich hunting ground for investments which directly promote sustainability or carry the ESG label, such as green or social bonds. But that is changing. Issuance of ESG-linked commercial paper is slowly rising, and there are more opportunities appearing in the secondary market, too, as early-mover green bonds approach maturity and thus enter the time horizon of money market investors. Their number will only grow.

Overall, we see ESG as a natural complement to our conservative investment process. While we exclude investments that fall short of our ESG criteria and give an allocation premium to well-rated issuers, we retain the focus on liquidity and diversification that has always distinguished our money market franchise. 

For all these reasons, Pictet - Short-Term Money Market strategies have recently been classified “Article 8” under the European Sustainable Finance Disclosure Regulation (SFDR) – a rating awarded to investments that include ESG factors in their investment decision-making process and promote environmental and social characteristics.

Sustainability in practice

So what does that mean in practice?

Our approach is two-fold. Firstly, we have designed a negative screening plan. Our funds exclude a number of sectors from the investment universe, including tobacco, oil and gas, nuclear power generation, thermal coal, pesticides, gambling and weapons. We also exclude all issuers who breach the UN Global Compact Principles.

Fig. 2 - Reducing risk
Sustainalytics ESG ratings - Risk rating categories for Pictet-Short Term Money Market EUR strategy, % of portfolio
Risk ratings.png
Source: Sustainalytics, Pictet Asset Management. Data as at 30.09.2021.

Secondly, our investment process includes a positive tilt towards issues with strong ESG characteristics. That means that besides excluding companies with the worst Sustainalytics scores (ones with a controversy score of 5), we give an allocation premium to companies with negligible, low and medium risk (see charts). Keeping our conservative approach in mind, expressed by strict guidelines on diversification, our maximum allocation per issuer can be increased by 1 per cent based on their Sustainalytics rating and the credit analyst’s opinion.

Implementation was simplified by the fact that asset-backed securities – where sustainability characteristics of the underlying assets are notoriously hard to monitor – were never part of our investment universe as we judged them too risky for what is essentially a conservative and risk averse product.

Although we have had to make some adjustments to the portfolio to accommodate our ESG focus (such as disinvesting from some tobacco and oil companies), these have been very marginal from a performance perspective. There is still a sufficiently diverse universe to enable us to maintain high levels of liquidity and generate yield. And, as we don’t have any composite benchmark (instead comparing performance with cash or a cash equivalent index), there are no concerns about tracking errors, as there can be for other types of strategies. 

At Pictet Asset Management we take a responsible approach to investment management, and aligning our short-term money market funds with ESG principles is a natural part of that. In our view, ESG goes beyond a box-ticking exercise; it is very much an investment philosophy – and one that can be embraced successfully even on a short time horizon.