Is ESG Compatible with Passive Management?

We were recently invited by FT’s Pensions Expert to provide an article debating the potentially thorny question: Is ESG Compatible with the Rise of Passive Management? This brainteaser was born out of a plausible tension between two of this decade’s most significant trends.

Passive providers tend to be more - sometimes wholly - reliant on third party sources of ESG data.

At first glance, the immediate answer might appear to be “yes,” based on one simple development: the expanding universe of passive indices and semipassive (smart beta) products with an ESG dimension. They range from tilts based on ESG ratings - which can now be sourced from various suppliers - to specific themes such as decarbonisation, which has proven particularly popular among European pension funds.

Yet somehow the question, and this initial answer, seemed to miss the point entirely. The real debate is not whether ESG, in any sense, can be incorporated in the context of a purely heuristic or rules-based investment style. The question, instead, is what type of ESG integration is desired.

In practice, we are seeing increasingly specific and complex requirements from pension funds, endowments and SWFs. Some emphasise engagement; some prioritise climate change. A few are keen on negative screens, which can be applied to passive or active styles; a larger proportion are looking for ESG to be embedded in decision-making or even in the DNA and culture of the fund manager.

Depending on these differing priorities, investors should be aware of the potential limitations of “passive ESG.” Firstly, the availability and reliability of ESGrelevant data remains a challenge for active and passive managers alike. This is particularly true outside of the major developed markets. Yet, where passive providers tend to be more (sometimes wholly) reliant on third party sources of ESG data, active managers can draw on their own research to express specific views, augment third-party information and – as we frequently see in practice – disagree with those ratings.

Indeed, we saw an interesting example of this in early October, after Castlefield released a report entitled “Winners and Spinners.” One of those criticised, in a list which included both passive and active players, was the €588m Vanguard SRI European Stock fund. The firm’s spokesperson responded to media enquiries with this statement: “Vanguard selected FTSE as the index provider for this fund after evaluating FTSE’s screening process and ‘socially responsible’ criteria, however, we are not directly involved in decisions to exclude/include specific companies from the fund on an SRI basis. This strict segregation of duties avoids conflict of interest.”

The overall exposure at a firm level to each stock can influence how the manager spends its engagement time budget

Secondly, prioritising engagement may also be a challenge for passive managers. We have observed that, if and when passive managers undertake engagement, the overall exposure at a firm level to each stock can influence how the manager spends its engagement time budget. Since they tend to be substantial owners of the largest companies, passive managers may feel compelled to direct their attention accordingly, whereas active managers may exert influence at smaller companies where they invest (or divest/ short) with conviction.

Thirdly, expectations or objectives for the portfolio may not always be entirely clear. For the most part, passive ESG is being implemented with the intention of replicating – as closely as possible – benchmark-type risks and returns. Yet, at the same time, we see publications pointing towards outperformance, albeit over a short period of time, leading to claims about “ESG factors” and some blurring of the lines with the popular factor investing trend. What are board members and stakeholders anticipating Benchmark-like risks and returns or considerable tracking error – which can of course cut both ways? Is the potential for underperformance clearly understood?

So perhaps, for all its merits, “ESG passive” might not be the panacea initially suggested. Yet, if one chooses not to go down this route, does it follow that ESG is incompatible with the shift to passive management? Not necessarily.

There is more than one way to slice a cake. Commitment to ESG does not necessarily – depending upon a pension fund’s beliefs – mean that every single part in the portfolio must have an ESG dimension.

We see investors that have moved a portion of their equity to (non-ESG) passive or smart beta but express sustainability beliefs through ESG oriented active equity managers. There is also a major trend towards integrating ESG considerations beyond listed equity, particularly in private markets, as illustrated in recent publications such as ESG Under Scrutiny: Lessons from Manager Selection (ESG Private Debt) and DNA of a Manager Search: Infrastructure (Renewable Energy Infrastructure).

As long as limitations and objectives are appreciated, a diverse range of ESG preferences can be expressed through a combination of passive and active strategies across the portfolio. There is no “one size fits all.”