Are passives the problem? Five myth-busts on ESG and ETFs

Active managers do not have ownership over ESG. Developments in the index and ETF space are enabling investors to achieve their sustainable investment goals better than ever.

Theo Andrew

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There is often much navel-gazing from active managers over the passive approach to sustainable investing. While inevitably improvements can be made to the way both approach ESG – the plethora of incoming regulation and data issues means there is no perfect approach – the criticisms thrown at ETFs and passive investments are often overplayed and designed to keep vested interests front and centre.

With this in mind, ETF Stream thought it appropriate to set the record straight, busting five myths (there are probably more) often cast upon ETFs and ESG.

1. ETFs cannot engage with their holdings

The argument passives do not engage with their underlying holdings is an argument that is often volleyed at ESG ETFs by proponents of active strategies.

While it is the case that passive strategies delegate the choice of ownership of securities to the index provider and, in most cases, are therefore unable to divest, this means there is an even greater onus on engagement.

Because index-tracking ESG ETFs are unable to divest from a particular company, they have an even greater responsibility than active managers to constantly engage with individual companies while holding index providers to the highest of standards.

As a result, asset management giants such as Amundi and Legal & General Investment Management (LGIM) are able to combine their active and passive assets and leverage their in-house teams to engage with the companies they own.

2. Rules-based exclusions are an ETF’s only tool

Passive strategies are often called out for their rules-based exclusionary approach. However, this argument forgets that mutual funds – which often invest in much fewer stocks – exclude much more of the market.

This is important as it can be argued active funds are merely passing the problem of holding non-ESG assets to somebody else, creating a pot-kettle-black situation.

As Stuart Kirk, former global head of sustainability at HSBC Asset Management, argued at ETF Stream’sESG ETFs Investor Workshop event, ETFs have more “skin in the game” because they own more companies.

Furthermore, BlackRock’s decision to allow institutional investors the opportunity to vote directly with companies gives passive investors another string to their bow, through greater powers of engagement.

3. ETFs cannot do impact investing

Impact investing is another concept that active funds claim to have ownership over. While this kind of results-driven investing can often be hard to pin down, innovation in the ETF space is growing in this area too.

In September, index provider BITA and investing specialist iClima Earth partnered to develop five impact data, indices and analytics. For example, the Climate Change Adaption index will focus on solutions to help societies adapt to the consequences of rising global temperatures.

Another ETF designed to have an impact is the Rize Environmental Impact 100 UCITS ETF (LIFE) which launched in July 2021, meaning ETF investors do have options if they are looking to make an impact.

Furthermore, green bonds, which exist in both the passive and active space can be seen as one of the most effective means of achieving goal-driven investing.

4. Divestment is a useful tool

The ability of an ETF to divest in companies that do not meet its ESG criteria is not always a simple one and often requires frequent, or sometimes infrequent, index rebalancing to reflect its position, however, it is not always clear this is the right course of action anyway.

Divestment is often hailed by active managers as the ultimate weapon in their artillery. The ability to threaten the management of a company to pull their investment, should, in theory, make them stand up and pay attention.

However, the major risk here is that private capital such as individual investors and hedge funds – which care less about the ESG outcomes of the company – will swoop in to fill the gap. Not only does this lead to less insight and transparency but is potentially harmful to the environment, according to Kirk.

Fixed income ETFs can also play an important role here. Denying a company funding, as opposed to shifting it to somebody else as in the equity space, is also a powerful tool.

5. ETF investors are short-term in nature

Investors that only use ETFs as a strategic asset allocation tool do not hold the strategy long enough to affect any sort of change.

This is a problem when practicing ESG investing, or so the argument goes, as the money does not stick around for long enough to have any real impact.

However, a recent deep dive into flows shows the opposite to be true. In Q2 alone, ESG ETFs saw €6.7bn inflows – 42% of total flows into European-listed ETFs – according to data from Morningstar, despite the underperformance during the first six months of the year.

Highlighting how ETF investors are willing to ride out poor performance to meet their values.

This article was first published inESG Unlocked: Europe out in front, an ETF Stream report

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