Environmental, Social, and Governance (ESG) focused investment strategies are surging in popularity, while the drive for tax efficient returns through Tax Transparent Funds (TTF) is irresistible. The potential to combine both trends could deliver investor value, says Edward Turner, Global Product Head – Insurance Sector, HSBC's Securities Services, & Samantha Ray, Director Product Management – Insurance Sector, HSBC's Securities Services.

    Investor confidence is mending after the havoc wreaked by Covid-19, but the pandemic will have a lasting impact on the investment landscape. And, with interest rates continuing to scrape rock-bottom levels, institutional investors have their work cut out to achieve steady long-term growth.

    Against this backdrop, the advantages of Tax Transparent Funds look even more appealing. This structure is seeing significant growth as investors seize the chance to diversify portfolios, spread risk and achieve savings through economies of scale, while enabling investors to benefit from the tax treaties of their home jurisdiction.

    At the same time, investor enthusiasm for ESG strategies shows no sign of waning. Investors are now attuned to the merits of sustainability and there has also been a considerable amount of commentary on the relative resilience of ESG stocks during the pandemic. Institutional investors are embracing ESG wholeheartedly, and 2020’s record number of sustainable fund launches seems set to be surpassed this year.1

    Until now, TTFs and ESG strategies have been most often pursued in isolation. Increasingly, however, asset owners and managers are exploring the prospect of blending their benefits – and there are sound reasons for doing so.

    ESG strategies

    It is entirely feasible to use a TTF to create building blocks (i.e., sub-funds) embodying different ESG strategies across selected themes. The result would be a fund with elements touching on the key themes of ESG that are important to the investor base.

    Exclusionary strategies could be used, for example, to avoid exposure to investments linked to tobacco or fossil fuels. A thematic strategy might select stocks with the potential to deliver advances in climate change transition or in diversity and economic inclusion, whilst an engagement strategy could drive positive change via voting and board engagement.

    Investors could select from these sub-funds according to their own priorities, building a tailor-made, diversified ESG portfolio, trading units of each sub-fund as they see fit. For those investors looking for ready-made ESG portfolios, multi-asset sub funds could be created with a fixed allocation to the underlying building blocks, presenting investors with an easy way to achieve increased exposure to ESG assets.

    Sustainability plus efficiency

    Today’s investors are committed to ESG, but they also expect their asset managers to find the most efficient operating models/fund vehicles for that commitment. TTFs certainly provide that efficiency. They allow assets of different investment types to be pooled into a single fund, reducing the cost-income ratio through economies of scale.

    In tax terms, a TTF is ‘looked through’, with investors treated as if they held their share of the fund’s investments directly. In most cases, this allows them to preserve the benefits of tax treaties that apply in their home jurisdiction as income is generated. This is particularly important for institutional investors such as pension funds and insurers who may benefit from reduced rates of withholding tax on dividends compared to traditional fund vehicles. For example, where a UK pension invests via a Luxembourg SICAV which invests in US equities it would suffer 30 per cent withholding tax on US dividend streaming; whereas a UK pension investing via a UK ACS invested in US equities would suffer 0 per cent withholding tax on dividend streaming. Tax transparency (i.e. looking to the tax status of the investor rather than fund) savings can be substantial.

    Complementary strategies

    Asset Managers looking to target such investors will come under increasing pressure to offer their ESG strategies through a TTF, ensuring their investors can achieve their ESG investment objectives without giving up investment performance lost through the tax drag suffered in other funds. A number of high-profile asset managers have already established ESG-focused TTFs.

    Asset Owners using TTFs to pool their assets for the economies of scale benefits are now looking at their investment strategies and determining whether changes are required or if they should create new ESG-focused strategies. Having their investments pooled into a single fund makes assessing the ESG credentials of their strategies more straightforward and can enable them to choose best-in-class ESG mandates to be offered to all parts of their business and potentially even to external investors.

    TTFs and ESG strategies are models whose time has come – so it is fortuitous that these stars of the investment firmament are complementary. ESG-focused strategies fit easily into the TTF model. Whatever the ESG priorities of an asset manager or owner, they can be enshrined in a TTF in pursuit of sustainable and scalable growth.

    Data challenge

    The challenge for asset managers and insurers seeking to create such a fund is to assure themselves that the ESG data they gather in the selection process is robust. This is made harder because the intensity of demand for ESG-focused investment has outpaced the regulation around it: by 2020, the number of signatories to the UN Principles for Responsible Investment had passed 3,000, representing investment of USD103.4 trillion.2

    However, the regulators are now beginning to catch up and reporting requirements are being tightened. Large companies are already obliged to report ESG data under the EU’s Corporate Sustainability Reporting Directive (CSRD). These rules are set to be strengthened, quadrupling the number of companies affected. Meanwhile, the UK government is consulting on plans to require big and publicly listed businesses to disclose their exposure to climate change risks, potentially as soon as 2022.3

    Presenting ESG information in a way that is meaningful to investors is another challenge, given the variability of data. Again, regulation is starting to tackle this. Some clarity around the language of what exactly constitutes sustainable activity was introduced in 2020 through the EU’s Taxonomy Regulation,4 and the Benchmarks Regulation is designed to help ensure the transparency of ESG methodologies.5

    Clear benefits

    While none of this will make the process of ESG fund selection or governance a simple one, it offers useful signposting for asset managers and insurers as they seek a clear picture of performance. This will be critical to avoid any damaging perception of ‘greenwashing’ in future.

    With interest in ESG increasing and the standardisation of information a growing focus, asset managers and owners could see real benefits from utilising the tax efficiency offered by TTFs to help achieve their sustainable investment goals.


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