From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
Over the past few months I have seen media references to fund launches in the ESG space that sometimes have a caveat – that the ESG filters applying to the portfolio holdings exclude securities lending collateral. If I were an investor, this would give me pause for thought. Why the carve-out – is it because it’s not relevant, not possible, or for some other reason? As a qualifying observation for my comments below, collateral takers do not vote on shares so any exclusion must relate to purely holding the asset rather than the broad ESG criteria.
We should acknowledge and applaud the transparency here. First, the funds making these statement lend – funds typically lend in order to generate alpha or offset costs and it is increasingly a standard expectation that funds will lend. Disclosure is rightly a regulatory obligation but welcome nonetheless. Second, it would be very easy for a fund manager to gloss over the fact that it would be possible, and indeed almost certain, that over time, the fund could receive collateral that would not satisfy the ESG investment filter.
Now let’s turn to the “Why” questions raised above.
Is securities lending collateral relevant to the ESG question for investors in the fund? When securities are lent, the investor receives collateral – either cash or other securities. If cash, it gets invested into money market instruments such as commercial paper, money market funds or reverse repo. If securities are used as collateral, the title transfers from the borrower to the lender. Securities collateral is substituted on an ongoing basis, typically using third-party collateral management intermediaries (“tri-party” providers) that optimise collateral allocations on an intra-day basis. In both cases, the collateral assets form part of the fund property so yes, it is a relevant issue, and in normal operation it is virtually certain that assets not eligible for investment due to ESG filters could indeed be held in the portfolio. It is important to put these assets in perspective – if securities collateral, they are held temporarily until substituted for other assets. If instruments purchased with cash collateral, the holding period will be determined by the investment choices. Either way, these assets should be considered transitory in nature.
Is it possible to exclude assets that don’t comply with the investment criteria? As with many aspects of securities lending, the answer is “it depends”. That’s not a criticism of the business, rather it reflects one of its glories – a lender’s activity can be customised to meet its specific requirements. Turning to ESG, how specific can an investor be? I have seen two portfolio managers, each running an ESG ETF debate whether Facebook was eligible for their respective funds. One said “yes”, the other “no”. Similarly, I have seen funds avoid sectors – e.g. the oil and gas sector – whereas another portfolio manager will select “Company A” that has a better overall rating than “Company B” because of its efforts in renewables and transparency. That preference for A over B could of course change over time. In either case, the collateral schedule that a lender authorises can be adapted to reflect its needs.
Where securities are taken as collateral, differentiation can be made using Standard Industry Classification codes as a handy way of excluding industry segments from collateral. I have used this in the past to satisfy the needs of investors that wish to exclude the “vice” sector from acceptable collateral. Specific issuers can also be excluded from approved collateral at the ISIN/CUSIP level. There are also variants, but I trust you get the picture.
Cash collateral requires more work effort and likely would necessitate a segregated mandate. In order to make a segregated fund economically viable, the lender would need to be of a certain size. Nevertheless, it is not beyond the wit of investment managers to put together a pooled fund with a clear ESG mandate thereby giving lenders an option for cash collateral asset compliance.
Are there other reasons necessitating dispensation for securities lending collateral? The primary obstacles that come to mind are scalability, time and effort. I do not want to underplay the importance of scale in securities lending. Profitability depends on large transaction flows of relatively small values and standardisation of product delivery and hopefully loans outstanding for a reasonably long average tenure. Even the higher-margin trades only generate meaningful profits over time. So, I accept that client-specific solutions can increase costs for agents. However, it must also be the case that programmes need to come into line with investors’ ESG objectives and it behooves agents to take the plunge and engage, as some do already. Might this result in a change to fee schedules or could an enlightened agent seize ESG as an opportunity to differentiate itself from others? Time will tell.
Would a customised and somewhat narrower securities collateral schedule disadvantage a lender? In theory yes, wherever possible investors should have as wide a scope of acceptable collateral as their risk appetite allows. However, on a practical basis, once the tri-party collateral schedule is in place it operates in the background and borrowers are unlikely to discriminate on the trade execution end where an investor does not accept a subset of the widest collateral profile. It requires effort to put any non-standard arrangements in place. It requires time to discuss what the lender is trying to achieve and creativity on behalf of the agent to put in place a solution that meets the lender’s needs, but the best lenders and agents already have constructive engagement that this can build upon.
I’m sure there are other factors which I haven’t considered here and I welcome feedback from readers on the topic.
In any case, ESG is here to stay. Larry Fink, CEO of BlackRock, the world’s largest asset manager made that clear in his recent letter to clients: “Sustainability as BlackRock’s New Standard for Investing”. To the extent that securities lending holds itself out as requiring special handling and exemptions, it undersells its capabilities and mission to add value to its users’ investment objectives, and I would argue it would be doing so unnecessarily.