Passive versus active: the ESG debate

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.