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Can passive investing meet the ESG challenge?

A growing appetite for sustainable investments is forcing fund providers to think outside the box

The rising popularity of passive investing in recent years has prompted some industry figures to ask how much further its share of the market can continue to grow.

Active fund manager Baillie Gifford launched a campaign for “actual” investing earlier this month, in which it called for the industry to return to its “fundamental purpose” of making decisions to allocate capital where it will be most productive.

Others are predicting a brighter future for trackers, however, particularly with regards to how they can fit in with trends towards ethical investing.

Earlier this month, FCA chief executive Andrew Bailey said the rise of passives could continue to shake up the status quo in the investment industry, pushing active managers to review their moral codes under the watchful eye of the regulator.

Bailey acknowledged the need for both investment styles to keep ethical investing as a backdrop, but can they stay true to socially responsible credentials?

Looking for an equilibrium

Many active managers have stepped up their marketing efforts in recent years to position themselves as “truly” active, in the face of pressure from passive competitors.

A look at the numbers, however, suggests that active managers might not have as much to fear from trackers as first thought.

The Lyxor-Dauphine Research Academy – a partnership between Lyxor Asset Management and the Université  Paris-Dauphine House of Finance to conduct analysis into investment themes – is currently looking into the relationship between passive and active management, specifically the “role the growing passive space has left for active managers”.

The proportion of passively managed funds increased from 16 per cent in 2010 to 27 per cent of total managed funds worldwide last year. In Europe, passive funds represented 16 per cent of all managed funds compared with 10 per cent in 2010.

However, the LDRA points out that when looking at the size of actively and passively managed funds compared to the size of global financial markets, actively managed ones account for 20 per cent and passively managed ones just 8 per cent.

Lyxor has both active and passive offerings. Commenting on the research, Lyxor head of exchange-traded funds research Marlene Hassine Konqui says passives present competition for active managers, but they cannot replace the best of them, although active managers can take advantage of passive investment tools. Konqui adds that passives are likely to continue growing.

She says: “There is little sign that we are reaching a stable market share between active and passive funds.”

The pressure on active management from passives has made some houses change their behaviour, however. Baillie Gifford director of retail marketing and distribution James Budden says: “Passive investing has already redefined the role of active management.

“It challenges active managers to be different to the index and outperform it over the long term.

“If they fail to do this then investors will look to passive as a cheaper alternative. The real challenge for investors is to understand what makes a successful active manager.”

Budden adds that Baillie Gifford understands active managers as those with “high active share and low turnover, who believe in deploying clients’ capital into tangible, sustainable activities, allowing companies to grow and prosper over the long term, while still generating positive returns for investors”.

These clients are “actual” investors rather than just active ones, Budden says of the firm’s campaign to improve the capital allocation of active managers.

Castle-Phil-Financial Escape-2013 700 x 450.jpg

Adviser view

Phil Castle,
Managing director, Financial Escape

My firm has been an ethical and SRI specialist since 1998 and as a result, we then take a further step and construct our own model portfolios which can meet a range of clients’ varying SRI and ethical preferences to match the questionnaire we ask them to complete, in addition to a risk questionnaire.

My locum, who does the quantitative and qualitative research, does not take a position on particular ESG issues until a client expresses an ESG preference, but does then adjust recommendations and sometimes refers this back to me.

The interesting thing from my perspective now, however, is that based on his research, he gives me a list of 13 core funds, of which seven are ESG in one shape or another.

Meeting the ESG test

When FCA chief Bailey spoke about shifts in the investment management industry, he said the rise in passives could go hand in hand with another prominent trend for the sector: a demand for ethical and socially responsible investing.

While some think passive funds cannot pick investments based on their ethical qualities because they simply follow an index, Bailey said passives and environmental, social and governance issues can in fact be blended. He noted: “A longer-term shift towards passive investing goes alongside a desire for more ethical and socially responsible investing, and a desire to encourage longer-term patient capital. Of course, these two developments can co-exist.

“Indeed, I would go so far as to say that they will, and that in doing so there will be some re-clarification of the meaning of active investment.

“Passive investment suits the needs of a lot of investors, at least in part. But it can co-exist with a world where investors also want to express a preference which embodies their values and longer-term goals, with ethical objectives for instance.

“And I would argue that an industry which enables the support of patient capital and innovation, and of ethical investment and social responsibility, will be one where the trust will be stronger and deeper, and the culture will prosper.”

Investment uncovered: How to pick a passive fund

In the past, investing with an ESG focus in mind has been seen as confined to active management.

In September, Royal London Asset Management published a paper which argued that too much passive investment could negatively impact stewardship and corporate governance over companies, because of the lack of manager pressure.

It said that the growth of passive investing, which tries to keep costs low, could hurt the overall quality of corporate governance, as tracker-style offerings would not have budgets for research and engagement with the boards of listed companies.

But spotting companies living up to good ESG standards may be something passive managers can achieve.

Improving quality of data on companies and progress in the technologies behind indexing have paved the way for more approaches to passive sustainable investing.

Last month, the index provider MSCI launched a series of ESG-screened indices, which aim to exclude companies associated with thermal coal and oil sands extraction, as well as those with revenues from nuclear weapons, civilian firearms and tobacco.

Companies violating the United Nations Global Compact principles on human rights, labour, environment and anti-corruption will also be excluded.

Along with indices that use negative screening for companies associated with tobacco, or similar cardinal sins against good ESG ratings, there has been an increase in thematic trackers, which often tackle particular environmental or social issues.

Most of these trackers are environmentally focused, while other thematic ETFs address social or governance issues. Lyxor and UBS have introduced global gender equality ETFs, which invest in companies with the highest gender equality scores globally.

Morningstar data (see chart) shows that last year, the number of launches of sustainable ETFs outnumbered launches of their traditional index fund counterparts.

Despite the challenges that passive ESG-conscious investments pose to active ones, active fund managers can still claim to hold some advantages.

For instance, where a company acts against ESG standards, an active fund manager can react with immediate effect by selling shares.

Moreover, while the quality of readily available data on companies’ ESG credentials has improved, in-depth research by a dedicated active manager can potentially still beat computational screenings.

This can particularly be the case in certain emerging markets, where ESG data is of poorer quality, handing active managers their moment to shine.

Socially responsible investment screening tool Fund EcoMarket founder Julia Dreblow believes active managers will always have the advantage when picking ethical investments. Despite this, she says that it is better to have a passive ESG screen than none at all.

Dreblow adds: “Just as long as they do something, it doesn’t matter if it’s active or passive.”

Head to head: Can passive and ESG investing co-exist?

Yes

Improved data, advances in technology and sophisticated indices, as well as increased demand for low-cost solutions, have driven interest in ESG ETFs. When I compared performance data in four Morningstar categories, I saw on average that ESG ETFs had outperformed their active peers.

We have seen a round of ESG ETF launches recently. Last month, two providers, iShares and Legal & General, launched a series of ETFs that screen out companies based on ethical criteria, and they also usethe UN Global Compact. There’s demand for ethical exclusion. In the ESG space, you often hear we have moved from exclusion more towards ESG integration. But providers survey the market and this is what people want. Also, an exclusionary screen is easy and cheap to implement, which allows providers to issue products at very low cost. So these products charge the same fees as other core products. This fights the perception that you have to pay a premium to buy an ESG product.

Because the charge is the same, there is no difference, except one product is more ethical. In Europe, this is what people want; to invest more responsibly, as they think some companies offer products that don’t fit in with that and never will.

Hortense Bioy is Morningstar Europe’s director of passive strategies and sustainability research

No

Active funds make a considered and conscious choice about owning each company. This includes taking a view on quality of management, and the ability of the board to provide effective oversight. Active funds have the ability to allocate capital away from poorly governed companies. They can often dedicate more time and resources to engaging with management in an effort to solve problems. Individual fund managers in active funds have a clear incentive to push for improvements. Passive funds, on the other hand, cannot play a role in capital allocation. They must rely on voting and engagement to make change and often their resources can be spread thinly.

It comes down to the ability to consciously allocate capital to companies that are helping solve some of the world’s most challenging problems.

Although they play an important role in the market, passive funds will be less effective in this capital allocation.

ESG ETFs play a role in providing people with low-cost options for investing in strategies that integrate ESG considerations into investment decisions, and we expect to see these strategies grow as investors become more interested in responsible investing. These passive funds are an important part of our asset mix but ESG ETFs and tracker funds cannot be as effective as active funds in allocating capital to companies that provide positive environmental and social benefits.

Ashley Hamilton Claxton is RLAM’s head of responsible investment

The tone from the top

The regulator is looking to make consideration of environmental and ethical issues a default position for investors.

In his speech, Bailey said that the FCA was consulting on rule changes that would require independent governance committees of contract-based pensions to report on how firms incorporated environmental risk management and ethical concerns of investors into their investment strategies.

He also mentioned the work being done in clarifying trustees’ fiduciary duties to consider long-term risks and opportunities, and to outline how they take account of financially material risks and opportunities, including climate change.

The watchdog’s remarks show a desire to make screening for environmental as well as ethical issues mandatory, assigning this task to IGC members and fiduciaries in the case of institutional investors.

This could potentially have a significant impact, given the proportion of total funds managed by institutional investors.

According to data from the Investment Association, almost four fifths of assets under management in the UK last year were managed on behalf of institutional investors.

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  1. Bearing in mind that passives just lump everything together and you get all the dross included with the good stuff, I would have thooght that this sort of filter for a passive is practically impossible.

    Indeed even if you are selecting specific active funds or even direct holdings in this category, what might be ESG or ethical to one person, might not be to another. Even if there is a consensus, boards and trading conditions change so even for active managers they have to be constantly on the ball. For example Facebook may have been selected on one or more of these criteria a few years back, but i would have thought, even for the least fastidious, that would fail miserably at the first hurdle today. My guess is that the same would apply to Tesla, Amazon and a host of others who may at one time been categorised as ‘the good guys’.

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