Passive versus active: the ESG debate

Can passive funds be truly compliant with environmental, social and governance concerns, and if not does this open up opportunities for a more active way of investing?

Two of the strongest trends in investing over the past few years have been the move from active fund management towards passive funds and growth of interest in environmental, social and governance (ESG) issues. 

But there are questions over whether the two can be compatible or whether increasing demand for ESG investing represents an opportunity for discretionary or active managers to attract customers. 

One of the reasons why ESG investing is only possible with actively managed funds, many wealth managers argue, is because of the absence of well-established, easily verifiable ESG indices. 

“This is partly because these issues are complex and there are no concrete definitions,” says Tim Cockerill, investment director at Rowan Dartington, an active manager and an early adopter of ESG. “For example, do you exclude BP because of its focus on fossil fuels or include it because it’s a major developer of renewable energy technology?”

There are other challenges, as Marc Naidoo, partner at solicitors McGuireWoods London, points out. “An ESG fund might raise cash for ESG projects, but this is commingled with the rest of the firm’s accounts. If an investor wants to know their money has been invested into green projects, the fund manager can’t be sure exactly how much, if any, has gone to which project,” he says.

Another issue with sustainable investing is the broad scope of the term. “Some of these assets might be very small and even if a few thousand of them are securitised into a passive investment fund the interest they pay will diverge considerably,” says Naidoo. “It’s therefore very difficult to calculate standard rates of return for investors.”

Although there are some passive exchange-traded funds (ETFs) in the ESG space, an active investment strategy is crucial to assessing portfolio suitability over the long term, according to Jonathan Hives, managing director of financial planners Arlo Group UK & Arlo International. 

“Fund managers need to continually ensure the underlying stocks continue to fit with ESG criteria and this is not something that is usually part of a passive strategy,” he says. “In this instance, fund managers would be relying solely on the companies themselves, which can be a much riskier approach.”

Active management enables investors to have more detailed conversations with companies about key ESG issues and to explore their records, activities and policies. Many passive strategies are retrospective and only reviewed annually. Active managers can also switch investments more easily.

“ESG-related concerns may warrant divestment from certain companies with significant controversies, or where engagements are unsuccessful, whereas passive funds do not have this advantage,” says Ken McAtamney, head of the global equity team and portfolio manager at William Blair.

A lack of dialogue and close scrutiny with companies means passive ESG investors could be missing out on opportunities to invest in companies that don’t shout their sustainability credentials, says Melissa Scaramellini, ESG fund research lead at investment manager Quilter Cheviot. She believes that there are increasing opportunities for those interested in the ESG agenda who want to use passive funds. 

“Some passive approaches are well thought through and can be appealing as low-cost investment strategies,” says Scaramellini. “There are also some interesting passive approaches being launched, for example strategies that align to the European Union climate transition benchmark where a specific reduction in the portfolio’s carbon footprint is targeted as well as further year-on-year reductions.”

Certainly, passive ESG funds seem to be attracting investors, albeit slowly. According to Morningstar, as of the end of last year, the share of passive strategies in the European sustainable funds market increased from 18 to 22.5 per cent over three years.

There are also opportunities to tackle the challenge of creating well-established ESG indices, thanks to better ESG company data disclosures, according to Maryia Semianchova, director and global manager of research at RBC Wealth Management.

“This enables the creation of more robust ESG methodologies and indices by financial information firms, such as MSCI, FTSE and Sustainalytics, and fuels development of increasingly credible passive ESG options that go beyond simple exclusion screens employed by early versions of green-labelled ETFs,” she says.

ESG ETFs have seen a steady but strong growth over the past five years with a notable uptick in the last 12 months. More than half of all new inflows to ETFs at the start of the year were ESG focused, according to Charles Sincock, managing principal at Capco, a technology consultancy with a financial focus. 

“This shift, coupled with an increasingly widely held view that ESG is no longer a niche differentiator or asset class, but rather a fundamental investment strategy, and hence should not be overpriced, has driven the popularity around ESG ETFs,” he says. 

Manuela Sperandeo, BlackRock’s Europe, Middle East and Africa head of sustainable indexing, says: “An index-based approach to ESG investing enables investors to implement their sustainability preferences in an explicit and consistent way across their entire portfolio. Index investing is often conflated with a perceived dormancy or lack of flexibility that does not truly reflect the wide variety of ways investors use ETFs and index funds to take control of their investment outcomes.”

The company’s newly launched iShares S&P 500 Paris Aligned UCITS ETF and iShares MSCI World Paris Aligned UCITS ETF are designed to mitigate exposure to capture opportunities arising from the transition to a lower-carbon economy. 

It may well be that over the next few years, as ESG investing becomes the norm and sustainability indices continue to improve, investors will be unwilling to pay a premium for sustainability, placing new demands on both active and passive funds, but also offering them new opportunities.