What lives in a biodiversity fund?

HSBC’s biodiversity ETF, PIMCO side pockets and thematic generalists made headlines this week

HSBC Asset Management became the latest issuer to launch a biodiversity-linked ETF this week, but question marks remain over how to foster biodiversity in a diversified and investable exposure.

The HSBC World ESG Biodiversity Screened Equity UCITS ETF (HBDV) tracks the Euronext ESG Biodiversity Screened World USD Index, a joint venture with Iceberg Data Lab, a biodiversity specialist which also provides some of the underlying data to the ETF Ossiam Food For Biodiversity UCITS (F4DU).

HBDV’s benchmark captures the top 500 companies in the Euronext World index in terms of corporate biodiversity footprint and Sustainalytics ESG risk score.

The ETF also aims to beat its parent benchmark’s biodiversity footprint by around 35% by eliminating companies involved in animal testing, palm oil production, pesticide production and wildlife hunting. whale – as well as the usual suspects of ESG exclusions such as thermal coal and oil. sand extraction.

The additional biodiversity screens are certainly significant, however, they may not go far enough for some.

For example, the ETF’s benchmark is inspired by the principles of the Task Force on Nature-Related Financial Disclosure (TNFD), which encourages companies to disclose activities related to ecosystem degradation, loss of biodiversity and indirect factors such as water use, water and land pollution, air pollution and waste generation.

Taking these principles and drawing inspiration from the United Nations Sustainable Development Goals regarding life on land and in water, one would expect additional explicit shields against corporations engaged in any form of deforestation, trawling , gas flaring and harmful substance spills.

Euronext considers supply chain environmental incidents, operational incidents and product and service incidents in its exclusion criteria to some extent, however, its index includes companies that do not lack biodiversity risk upstream or downstream of their supply chains.

These include agricultural specialists such as Deere and Co, construction and industrial companies and asset management names such as S&P Global, Nikko Asset Management and Nomura, whose products often channel investment directly into companies that, on their own, would be excluded from Euronext’s biodiversity benchmark.

Overall, HBDV should be given a quarter for not investing directly in worst offenders – and it certainly does a better job than Ossiam’s F4DU, whose top ten allocations include McDonalds and Ahold Delhaize – which, these years, has partnered with Cargill, which is among the largest contributors to deforestation in Latin America, according to the NGO Mighty Earth.

In the future, it would be good to see more attempts by ETFs on biodiversity impact capturing recycling companies, water and waste management companies, ecotourism and food manufacturers. alternatives to meat.

The TNFD also suggested that companies should be rewarded for their positive impact on biodiversity. ETF issuers may consider rewarding companies that actively use recycled materials in their products or those that spend on reforestation, among other activities.

Compartmentalize the risk

PIMCO has introduced the side pockets option to segment Russian sovereign debt exposure from the rest of the baskets in its emerging market bonds, low euro duration corporate and short euro maturity ETFs.

The decision follows regulators such as the Financial Conduct Authority (FCA) and the Central Bank of Ireland allowing the use of side pockets in July for UCITS funds for assets directly affected by the Russian invasion of Ukraine. .

The side-pocket mechanism allows issuers to segregate illiquid assets into a new share class, meaning they are priced differently from the rest of the fund – allowing existing shareholders to redeem the most liquid part of the basket and new investors to enter without being exposed to illiquidity.

Last month, Schroders became the first asset manager to use the new side pocket rule. Most often used by hedge funds to siphon off “hard to price” securities, the mechanism has been treated with suspicion by regulators for fear that active managers will be encouraged to make riskier investment decisions.

Are the themes becoming too general?

Following liquidity and over-concentration risks faced by BlackRock clean energy players, S&P Dow Jones Indices created a new benchmark for ETFs with a higher market capitalization threshold, minimum daily trading volume requirements higher and triple the number of target constituents.

Just over a year later, BlackRock’s ETFs in water, agribusiness, timber and forestry are set to undergo similar revamps – towards broader baskets of large companies – as SPDJI consults the market to give their underlying indices similar makeovers.

Earlier this week, ETF feeds also reported on an Industry Ventures paper, which found that technology companies are taking twice as long to register on average as they did in 1989, with three times the annual revenue and up to six times the size of their predecessors – meaning ETFs have to wait longer and longer to capture the growth stories of potential future disruptors.

A question many investors will have to ask themselves is whether this gradual trend of capturing more and more mature companies is undermining the use case for thematic ETFs – as tools to capture future winners – or whether the added security of the rule-based approach is a valid trade-off. -off for the early growth phase of missing companies.

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