Exclusion Request vs Tracking Error Budget
You advise a £250 million UK charity on a segregated global equity mandate. The benchmark is FTSE All-World, the active risk budget is 150 bp, and the investment policy statement excludes thermal coal revenue above 5% and controversial weapons. It also says the charity should avoid companies with severe human rights controversies, but sets no numerical threshold or named list. A benchmark constituent is 3.8% of the index. It has 6.1% revenue from thermal coal and a joint venture named in a credible NGO report alleging forced labour at a subcontractor; the company disputes the finding. Your expected excess return from holding it is 40 bp. Excluding it would raise ex-ante tracking error from 140 bp to 185 bp, above the risk budget. One trustee says the human rights clause is mandatory; another says the risk budget and fiduciary duty prevent exclusion. The mandate says ESG factors may be considered but does not define an exclusion process.
1. Interpret the mandate and decide whether to exclude the holding.
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The policy has two layers: a clear numerical exclusion for thermal coal above 5%, and a principles-based human rights clause without a threshold. The coal test is mandatory and the holding fails it: 6.1% is above 5%. So the exclusion decision is not really discretionary. The human rights allegation is less clear; a credible NGO report is not a legal finding, but the mandate says avoid severe controversies. The 40 bp expected excess return cannot override a clear exclusion. For the human rights part, commission a controversy assessment, engage, and set a temporary watchlist rather than automatic exclusion unless the allegation is corroborated. The tracking error breach is an implementation problem, not a reason to ignore the policy. The investment policy statement governs; fiduciary duty includes honouring the mandate.
2. Recommend implementation that respects both the exclusion and the risk budget.
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Sell the 3.8% position to satisfy the coal exclusion, but manage the risk budget actively: use the proceeds for a basket of lower-coal utilities or a transition-focused alternative, and re-optimise the remaining portfolio. If ex-ante tracking error remains above 150 bp, ask trustees for a temporary tolerance or a benchmark change rather than silently breaching the limit. For human rights, place the name on a watchlist, vote against the responsible director, and set a 90-day engagement deadline; exclude if corroborated. Clarify whether the 5% threshold applies to revenue or reserves and document the interpretation. Avoid using a broad best-in-class label to retain a non-compliant name.
3. What documentation and client communication are required?
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Document the mandate interpretation, the coal test calculation, the controversy evidence, the tracking-error impact and the trustees' decision. Report to trustees before trading if the policy requires it; otherwise notify them promptly. In client reporting, distinguish exclusions from engagement and from ESG integration. Disclose any tracking-error tolerance request and its rationale. Keep an audit trail suitable for the charity's annual report and any regulatory review. Communication should state what was excluded and why, what remains on watchlist, and how the risk budget was restored.