Legal & General Future World ESG Emerging Markets Index: February 2024 fund update

• Legal & General is one of the UK’s leading providers of responsible passive funds.

• We think this fund offers an attractive blend of responsible and passive investing across emerging markets

• It could be a good addition to a broader responsible investment portfolio

• This fund features on our Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

The Legal & General Future World ESG Emerging Markets Index fund is a good option for broad exposure to a range of mostly large and medium-sized companies in emerging markets, while being mindful of environmental, social and governance (ESG) issues.

These markets are higher risk as they're at an earlier stage of development, so this fund should only be considered for a portfolio with a longer investment outlook that can tolerate periods of higher volatility.

An index tracker fund is one of the simplest ways to invest, and we think this fund could be a great low-cost starting point for a portfolio aiming to deliver long-term growth in a responsible way. It could help diversify a portfolio that is heavily invested in developed markets like the US or Japan and add a responsible tilt. It could also be a good addition to a portfolio of other tracker funds.

Manager

Legal & General are one of the largest providers of index tracker funds in the UK and have offered index funds to investors for over 30 years. They have one of the best resourced and experienced teams in tracker fund management. This enables them to track indices as tightly as possible and keep costs low for investors.

Each equity index fund at Legal & General has a primary and secondary manager, although in practice it is very much a team-based approach.The primary manager for this fund is Shane Padden. He joined Legal & General in 2022 and is responsible for a range of equity index portfolios. Prior to this, Padden spent three years at Mercer working as an Investment Consultant. The secondary manager for this fund is Konstantins Golovnovs. He is responsible for managing a range of funds with both UK and global equity mandates. Golovnovs joined Legal & General as part of the graduate scheme and moved into his current role in index funds in 2011.

Process

This fund aims to track the performance of the Solactive L&G Enhanced ESG Emerging Markets Index. It invests in roughly 1,650 companies compared to the index which invests in over 1,800. It’s not always possible to invest in every company in the index and in the same proportion because it's difficult to buy and sell the smallest companies quickly or at low cost, which impacts performance. This is why the fund adopts a partial replication approach which helps it to closely match the performance of the index.

The fund invests in emerging markets including Taiwan, India and China and across a range of sectors with communications and technology making up the largest portion at nearly 40% followed by banks and the consumer sectors. South Korea isn’t included in all emerging market indices but is included in this fund’s index and currently makes up around 10% of the fund. It also invests in smaller companies which feature in the benchmark, these companies can be subject to more extreme price movements, and this can increase risk.

The fund won't invest in persistent violators of the UN Global Compact Principles (a UN pact on human rights, labour, the environment and anti-corruption) or companies involved in tobacco and controversial weapons. The fund’s exclusions include companies that earn more than 20% of their revenues from the mining and extraction of thermal coal, as well as companies that derive more than 20% of their revenues from thermal coal power generation and oil sands.

The index increases investments in companies that score well on a variety of ESG criteria – from the level of carbon emissions generated, to the number of women on the board and the quality of disclosure on executive pay. It also reduces exposure to companies that score poorly on these measures.

The advantage of reducing investments in poorly-scoring companies, rather than selling their shares completely, is that the Legal & General team can engage to help them improve. An increased investment in exchange for improvement on various factors is also a good incentive, so investors' money could make a positive difference.

The fund also adopts a decarbonisation pathway. This means it aims to reduce emissions by 50% relative to the unadjusted benchmark and thereafter achieve at least a 7% reduction in carbon emissions per year until 2050. The goal is to align the fund with the Paris Agreement, which aims to limit the temperature rise caused by global emissions to 1.5°C above pre-industrial times. We think this is a positive step overall, but it increases the fund’s complexity.

Culture

Legal & General has continued to develop their passive fund range over the last 3 decades. It has just over £470bn invested in this part of the business, allowing it to offer a wide range of index-tracking options.

It’s built a team of experienced passive fund specialists and they’re innovative too. If an index doesn’t exist for a sector they’d like to track, they’ll often work with index providers, like Solactive in the case of the Future World ESG Emerging Markets Index, to create a suitable index for them to track.

The team running this fund work closely with various risk departments across the business. We believe this provides support and adds challenge where appropriate.

Employees are also encouraged to participate in Legal & General’s share save scheme which should encourage them to be more engaged with the growth of the company. In addition, a portion of portfolio managers’ bonuses are invested into the funds they manage. By doing this, their interests are further aligned with the investors in the fund.

ESG integration

Legal & General Investment Management (LGIM) is predominantly a passive investor, but we are impressed with the extent to which they have woven ESG into their culture. Being a primarily passive fund house hasn’t stopped them being innovative when it comes to ESG. In May 2019, the firm launched its ‘Future World’ range of funds.

The Future World range incorporates LGIM’s ‘Climate Impact Pledge’, which is their commitment to assess and engage with around 1,000 of the world’s largest companies on how well they manage the implications of climate change. Companies that consistently show a lack of awareness of climate change, and do not respond positively to engagement, are sold from the Future World funds.

In 2019, LGIM established its Global Research and Engagement Platform, which brings together representatives from the investment and stewardship teams, in order to unify their engagement efforts. Engagement is conducted in line with the firm’s comprehensive engagement policy. A detailed description of the firm’s engagement and voting activity (including case studies) is available in their annual Active Ownership report.

LGIM’s Stewardship team is responsible for exercising voting rights globally, both for LGIM’s active and index funds. Voting decisions are publicly available through a tool which allows a user to search for any company to find out how LGIM voted.

Cost

The fund has an ongoing annual charge of 0.20%. This is more expensive than some other emerging market trackers, but we think it's a reasonable price to pay given the additional ESG analysis that takes place. Our platform fee of up to 0.45% per year also applies.

Performance

Since the fund launched in April 2022, it has returned -4.66%* versus -3.75% from the Solactive L&G Enhanced ESG Emerging Markets index. As is typical of index tracker funds, you would expect the fund to fall behind the index over the long term because of the costs involved in running the fund. However, the techniques used by the managers have helped to keep performance as close to the index as possible.

Over the last 12 months, the fund has delivered returns of -7.29% compared to the benchmark’s return of -7.11%. China has faced significant challenges over this period which has dragged on the performance of broader emerging stock markets. Expectations that China’s economy was going to thrive after the country came out of lockdown fell short and the property market crisis has been a continual headwind. With investors losing confidence, recent efforts have been made by the government to boost the stock market.

Despite these challenges, other areas have performed well and emerging markets remain promising for investors who are willing to accept the higher level of risk and volatility that is associated with them. Optimism about India’s growth prospects has attracted investors over the year. India’s stock market has reached record-breaking highs and has overtaken Hong Kong to become the fourth largest in the world.

Due to the exclusions and tilting mechanism, we would expect the fund’s performance to differ slightly from non-ESG emerging market indices. Over the last 12 months, the fund’s lower amount invested in oil & gas and utilities has held back performance as they have been the best performing sectors.

The fund has a relatively short track record, but Legal & General’s team has a longer one managing a range of other tracker funds. Their size, experience and expertise running index tracker funds gives us confidence the fund will track its index tightly and efficiently over the long term, although there are no guarantees.