Sustainable investing has historically been associated with active management.
But passive strategies can also incorporate environmental, social and governance criteria, and the growing flows into passive ESG investments are evidence that an increasing number of investors believe in the merits of a passive approach to sustainability.
Improved ESG data on companies and technological advancement over the past decade or so have made new approaches to passive sustainable investing possible.
As of April this year, there were 287 index funds and ETFs with an intentional ESG mandate globally, with collective assets under management of approximately $108bn (£80m), according to Morningstar data. This figure has increased threefold over five years, driven by a combination of inflows and new launches.
As chart 1 shows, however, growth across regions has not been uniform. While US assets have quadrupled over the past five years, it still lags Europe. European passive ESG fund assets account for 85 per cent of the global total, largely supported by institutional investors with sustainable mandates, particularly Scandinavian public pensions, sovereign wealth, and insurance funds.
Historically, these investors have had a preference for conventional index funds over ETFs, as index funds hold around 91 per cent of all passive sustainable fund assets in the region (chart 2). This compares with a near 50/50 asset split between index mutual funds and ETFs in the wider European market for passive funds.
But recent flows suggest that the gap between index funds and ETFs in the ESG space is closing, especially as the menu of sustainable ETFs is fast expanding.
Last year was the first that new ETF launches outnumbered those of index funds (chart 3). ETF providers were also particularly active during the first four months of this year, with 10 new ETF launches, double the number of new launches in index funds. This reflects the more dynamic and innovative nature of the ETF market.
Interestingly, the 10 new ETFs all track MSCI indices and exclude tobacco companies (table 1).
There is clearly a growing desire among investors and fund managers to divest from the tobacco sector due to concerns about public health, as well as human rights abuses and the substantial economic cost associated with tobacco.
Large European asset management companies such as Robeco, BNP Paribas AM and Aegon have recently announced they will cease all investment activities related to that industry.
The new crop of funds is bolstering the range of broad-based passive sustainable offerings, which currently represents 93 per cent of passive sustainable assets in Europe (chart 4). These funds track indices that incorporate ESG criteria in a holistic manner while keeping broad market characteristics. They are diversified and usually suitable as a replacement for a core holding within a portfolio.
While broad-based ESG funds dominate the landscape, thematic funds are gaining prominence, especially those focused on climate change, an issue that is increasingly resonant with investors.
Environmentally themed funds account for almost all European thematic fund assets, while there are currently only two socially themed funds in Europe, both of which are gender-focused. The two Global Gender Equality ETFs launched by Lyxor and UBS in 2017 invest in companies with the highest gender equality scores globally.
Meanwhile, fixed income passive funds remain under-represented, with less than 3 per cent of passive sustainable assets in Europe are in bond funds. This compares with a figure of 25 per cent across the wider passive universe.
Growth in the space has been hampered by the challenges of assigning ratings to government debt, an underdevelopment of fixed-income indices and, in the case of green bonds, a lack of suitable bonds themselves. This imbalance is a striking feature of the market and is likely to be an area of growth in the coming years.
Looking ahead, investor demand, coupled with better data quality and disclosure, will continue to drive product development. Specifically, we expect to see more passive funds investing in themes derived from the United Nations Sustainable Development Goals. Low carbon in particular may continue to grow.
We also expect to see more strategies aiming to capture ESG momentum. Numerous studies report that an improvement in ESG characteristics leads to increasing valuations over time. In fact, these findings, coupled with others extolling the risk-reducing benefits of sustainable investing, have sparked a search for an “ESG factor”.
Another area of growing interest is the integration of ESG criteria into factor strategies. The L&G Future World Equity Factors Index fund, launched in January 2018, is the most recent example of this growing trend.
The fund targets four factors – value, quality, low volatility and small size – while meeting positive carbon and environmental criteria.
Hortense Bioy CFA is director of passive strategies and sustainability research at Morningstar Europe