Passive versus active: the ESG debate

Passive versus active: the ESG debate

Two of the most prominent investment trends in recent years have been the shift from actively managing funds to passive funds and the growth of interest in environmental, social and governance (ESG) issues.

But the question arises as to whether the two can be compatible or whether the growing demand for ESG investments represents an opportunity for discretionary or active managers to attract clients.

One of the reasons ESG investing is only possible with actively managed funds, say many wealth managers, is the lack of well-established and easily verifiable ESG indices.

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

There are other challenges, as Marc Naidoo, partner at Solicitors McGuireWoods London points out. “An ESG fund can raise cash for ESG projects, but it merges with the rest of the company’s accounts. If an investor wants to know that their money has been invested in green projects, the fund manager cannot know exactly how much, if any, has been spent on which project, ”he says.

Another problem with sustainable investing is the broad scope of the term. “Some of these assets can be very small and even if a few thousand of them are securitized in a passive investment fund, the interest they pay will vary widely,” says Naidoo. “So it’s very difficult to calculate standard rates of return for investors.”

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

“Fund managers have to constantly ensure that the underlying stocks continue to meet ESG criteria and this is not something that is usually part of a passive strategy,” he says. “In this case, the fund managers would be relying only on the companies themselves, which can be a much riskier approach.”

Active management allows investors to have more detailed conversations with companies on key ESG issues and to explore their files, activities and policies. Many passive strategies are retrospective and only reviewed once a year. Active managers can also switch investments more easily.

“ESG concerns may justify divesting some companies that face significant controversy or where commitments fail, while passive funds do not have that advantage,” says Ken McAtamney, head of the global equities team and portfolio manager at William Blair.

A lack of dialogue and close monitoring with companies means that passive ESG investors could miss out on opportunities to invest in companies that don’t shout their sustainability credentials, says Melissa Scaramellini, head of research at ESG funds at Quilter Cheviot. She believes that there are more and more opportunities for those interested in the ESG agenda who wish to use passive funds.

“Some passive approaches are well thought out and can be attractive as low cost investment strategies,” says Scaramellini. “Some interesting passive approaches have also been launched, for example strategies that align with the European Union’s climate transition benchmark where a specific reduction in the portfolio’s carbon footprint is targeted as well as further reductions from year to year. year.”

To be sure, passive ESG funds seem to be attracting investors, albeit slowly. According to Morningstar, at the end of last year, the share of passive strategies in the European sustainable fund market rose from 18 to 22.5 percent in three years.

There are also opportunities to meet the challenge of building well-established ESG indices, through better disclosure of corporate ESG data, according to Maryia Semianchova, director and global research manager at RBC Wealth Management.

“This enables the creation of more robust ESG methodologies and indices by financial reporting companies, such as MSCI, FTSE and Sustainalytics, and fuels the development of increasingly credible passive ESG options that go beyond simple exclusion screens used by early versions of green labeled ETFs, “she says.

ESG ETFs have experienced steady but strong growth over the past five years with a notable rise over the past 12 months. More than half of all new ETF entries at the start of the year were ESG-focused, according to Charles Sincock, managing director of Capco, a financial technology consultancy.

“This shift, coupled with an increasingly widespread view that ESG is no longer a niche differentiator or an asset class, but rather a fundamental investment strategy, and therefore should not be overstated,” has boosted the popularity of ESG ETFs, ”he says.

Manuela Sperandeo, Head of Sustainability Indexing at BlackRock for Europe, Middle East & Africa, says: “An index approach to ESG investing allows investors to implement their sustainability preferences of explicit and consistent manner across their entire portfolio. Index investing is often associated with a perceived dormancy or lack of flexibility that doesn’t really reflect the wide variety of ways that investors use ETFs and index funds to gain control over their investment results. ”

The new iShares S&P 500 Paris Aligned UCITS ETF and iShares MSCI World Paris Aligned UCITS ETF are designed to mitigate exposure in order to seize opportunities arising from the transition to a lower carbon economy.

It may be that over the next few years, as ESG investing becomes the norm and sustainability indices continue to improve, investors will not be willing to pay a premium for sustainability, setting new demands. to active and passive funds, but also offering them new opportunities.

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