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Can cheaper passive funds be classed as ESG?

04 February 2021

In the first of a two-part series, Trustnet considers the role of passive funds within ESG investing and their limitations compared with an active approach.

By Rory Palmer,

Reporter, Trustnet

ESG – or environmental, social & governance – strategies have seen considerable inflows more recently, as investors realign their portfolios to reflect their beliefs. However, opting for low-cost, index-tracking passive funds in order to achieve this may not always reflect their own investment ideals.

Passive funds hold the constituents of a particular index, but what if that index contains stocks that disagree with the individual sensibilities of that investor?

Indeed, it can be difficult to satisfy the three distinct ESG factors within a single index, as an index could be consciously or unconsciously weighted towards one factor over the other.

For instance, the Dow Jones Sustainability index contains mining, airline, and tobacco companies, which might not fit in with everybody’s idea of an ESG benchmark.

If a passive manager has to own everything in an index, can it be considered effective ESG implementation? Active managers can sell their positions if the stock does not meet their required criteria and focus on finding the ESG winners of tomorrow.

With that in mind, Trustnet spoke to several market commentators for their views on ESG within passive strategies and what it means for investors.

The rigidity of the exclusion approach

Often, passive funds and the indices in which they track will have specific exclusion policies, but as a methodology it can be somewhat outdated and limited in its scope.

Ovidiu Patrascu, head of sustainable investment at the BAE Systems Pension Fund, explained that effective ESG policies have to go further than just exclusion.

“Investors are becoming more discerning,” he said. “They expect more from their investments than the simple screening out of controversial industries. Many recognise the benefits of robust ESG investment analysis rather than just as a compliance activity.”

“The real world is nuanced and complex, while indices are defined simply by what is included,” said David Blitz, head of quantitative research at Robeco. “In active sustainable investing, there can be a holistic, balanced, and detailed consideration of all environmental, social and governance inputs.”

This arguably one-dimensional approach is also highlighted by Rebecca Craddock-Taylor, director of sustainable investment at Gresham House.

“Passive ESG funds invest in line with an index constructed using ESG ratings, this is akin to hiring someone after reading their CV alone,” she said. “Active ESG funds go beyond looking only at the rating by conducting additional research, meeting management, and reviewing other relevant data points before investing.”

Despite this perceived rigidity, the low-cost passive option does provide investors with an affordable sustainable option, said Matthew Wiles, co-manager of the MyFolio Sustainable fund range at Aberdeen Standard Investments.

“Without passive ESG funds, investors would be left with a choice between traditional market cap passive and higher cost, more concentrated active ESG exposure,” he said. “Exclusions are a useful and transparent starting point, but many enhanced passive funds go further than simply excluding certain types of companies.”

Data-driven analysis is inherently backward looking

Another common criticism of ESG passive funds relates to their reliance on historical data and, therefore, may be missing out on the winners of the tomorrow by focusing on the high-scoring companies of the moment.

Declan McAndrew, head of investment research at Foster Denovo, compared it to a rear-view mirror, which he said leaves these strategies less progressive and less forward thinking than active funds.

Robeco’s Blitz described it as a “structural flaw” in passive strategies that they are not able to assess the sustainability of a portfolio.

“If investors wish to have an impact on society, they need to invest in companies that are improving or have the ability to improve, as well as those companies that already have strong ESG profiles,” he said.

Blitz also noted that a large part of future energy transition will come from companies who are yet to emerge as strong ESG candidates.

“Active investors who understand this ‘path to improvement’ are able to invest in, and work with, companies that they believe will benefit from this transition,” he added.

Indeed, a company which may prove to be a thought leader in five years’ time may lack the current criteria to be included for ESG consideration, which would exclude it from passive vehicles.

“The solutions required to address the environmental and social challenges that we face are not necessarily included amongst ESG rating providers and therefore investors have to look beyond passive ESG funds,” said Gresham House’s Craddock-Taylor.

Aberdeen Standard’s Wiles believes the issue is not so clear-cut, however.

“Whilst ESG characteristics are important, they should be considered alongside fundamentals, sentiment and valuation,” he said. “It is these factors combined that will ultimately drive a company’s performance and determine the winners and losers of tomorrow.”

Nevertheless, Wiles conceded that the drawbacks in terms of identifying improving companies can be counteracted by effective diversification.

“There is no reason why investors cannot combine core positions in diversified, low-cost passive ESG funds and complement them with higher conviction active strategies that address of the limitations of passives,” he said.

ETFGI, a leading independent research and consultancy firm covering trends in the global ETFs and ETPs space, reported that assets invested in ESG ETFs and ETPs reached a new milestone of $187bn at the end of 2020.


Source: ETFGI

Selling a stock: the ultimate sanction?

Possibly the biggest criticism, and an extension of the rigidity of passive ESG funds, is that they lack the ultimate sanction of being able to sell a stock.

“That rigidity is akin to accepting more compromises within the passive one as it’s a function of its structure,” said Foster Denovo’s McAndrew. “Stocks with a reputational risk cannot be disinvested unless they fall out of the index.”

Replicating an index is, of course, a feature of these vehicles and perhaps the issue lies within how this is communicated to clients and the trade-off of opting for a low-cost alternative.

“You’re leveraging off a client’s understanding of what the existing passive world is, rather than saying this is a low-cost alternative to the active ones,” he added.

Aberdeen Standard’s Wiles explained that passives by their very definition will never have the same flexibility as active strategies and should only be held if investors are comfortable with the exclusionary tactics that reduce exposure to negatively rated companies.

“Whilst selling a stock might be viewed as ‘the ultimate sanction’ it is far from clear that this is always the best route to pursue to fulfil an ESG or sustainability agenda,” said Wiles.

“When a stock is sold someone else is buying it, someone else who may have a complete disregard for ESG issues and a focus on short-term shareholder returns,” he added. “Relinquishing a holding in a company means that any voice in improving it or altering its direction is lost.”

“Passive managers can try to influence corporate policy with voting and engagement, but they cannot sell a stock if the management simply refuses to take them seriously,” commented Robeco’s Blitz.

He outlined the changeable nature of an index and the fluctuating weightings within it which require an active approach.

“That requires active risk management and active performance evaluation techniques,” said Blitz. “Passively replicating an ESG index does not circumvent these issues, as the index itself is still an active strategy.”

Stewards of capital influencing company behaviour

With that in mind, can these strategies effectively hold companies to account in the same way that active funds can and influence policy for the better?

“Effective stewardship of investors capital requires leveraging influence with senior management,” said Foster Denovo’s McAndrew. “You would not expect that in the passive world.”

While passive managers can influence positive change by voting at shareholder meetings, they are less likely to have the same incentive in driving corporate policy change as active managers.

“This has the potential to have a material impact should the holdings be of significant size,” said Aberdeen Standard’s Wiles. “As soon as a stock is sold it greatly reduces the ability to influence corporate policy in a meaningful way.

“The balance between divestment and engagement is a difficult trade-off with no simple answers.”

This argument holds true and can often be a very linear way of looking at engagement with companies in the active/passive debate.

“In some cases, passive managers will have more influence because of the size of the shareholding and the length of time they hold a stock,” said Gresham House’s Craddock-Taylor. “If a passive manager is asking for change, they can continue to persevere as they tend to be very long-term shareholders.

“Being a passive investor does not imply being a passive asset owner,” she added. “However, passive investors rely on their managers to be an active steward of the asset and use their ability to influence change regularly and consistently.”

However, if an investor is invested in a passive vehicle, the onus is on that individual to choose a manager that aligns to their ESG-related goals.

“Investors need to assess a passive manager’s commitment to engagement and voting activities, and then monitor how they hold companies to account on matters that are important to their own investment and sustainability objectives,” she said.

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