As the momentum behind environmental, social and governance (ESG) investing gathers a head of steam – or perhaps to reach for a more carbon-neutral metaphor, catches the wind in its sails – the passive versus active debate has migrated with alacrity.
This is wholly understandable. With ESG investing being perhaps the hot trend in investing right now, the various arms of the investment industry are staking a claim in a burgeoning sector. Active fund managers seeking a ‘killer app’ have seized on ESG as being one angle of attack, suggesting only by proactively attempting to fulfil the aims of the UN’s Sustainable Development Goals can truly responsible investment be achieved.
Hence, it was interesting to read the news reports of research from Paris-based strategic consultancy Indefi showing that institutional investors in the Netherlands, which up until now were proving to be big buyers of passive funds, are now thinking that active management could be a better option for them when it comes to sustainable investing.
Ric Van Weelden, partner at Indefi, explains it is no longer tenable to run separately a traditional fund range and a separate ESG-based range and that actually ESG should be viewed as a “risk management tool” across all investment products.
“Our impression is – based on the many interviews we have conducted in the Netherlands and elsewhere – that ESG is an intermediate step towards SDG (the UN Sustainable Development Goals) impact investing which brings together return objectives, long term risk management and execution on the agreement to achieve a significant and immediate reduction in carbon footprint.”
It is, he goes on to suggest, ‘ESG 2.0’ and, pointedly, he believes active might have the edge.
“Passive could have a bright future although in itself it tends to focus on investing in the economy of the past (as expressed through a widespread allocation to publicly quoted stocks),” he suggests. “So, passive can work well with stewardship or engagement but will be harder to envisage if you set out to achieve a carbon footprint reduction or other SDG targets.”
Follow the leader
Such theories were discussed in a white paper released last summer authored by Richard Klijnstra, head of sustainable value creation at Amsterdam-based fund manager Kempen. Suggesting the “transition to a “sustainable economy” would necessarily need further innovation, it meant further disruption was inevitable and the dispersion between the “leaders and laggards” would be considerable.
“In a period of high dispersion following the broad market in a passive solution is perhaps not the optimal strategy,” he wrote. “Being successful in selecting some leaders and avoiding most of the laggards will lead to a better result than the market average for example.”
Moreover, Klijnstra adds that he does not believe that ESG is being priced efficiently in the market. “Although there is much ESG and sustainability information disclosed publicly, often it can be difficult to identify and assess which information is most useful for making financially-related decisions. For efficiency broad accessibility, standardisation and transparency of information are needed.
“ESG and SDG data is becoming more widely available but is still limited and not yet fully standardised.”
He adds active ownership is also rewarded. “To identify and support sustainable leaders, now and in the future, we think active ownership is critical,” he says. “The purpose of active ownership is twofold: impact and insights. Impact to support and influence management, insights to understand the long-term prospects of the company.”
In comparison, a passive investor – almost by their very nature, is far less involved. “The passive investor does not engage with management to support sustainable value creation,” Klijnstra writes. “Even if a passive provider offers engagement services related to ESG it will not be an integrated approach based on the long- term potential of the business.”
Such is the theory. However, Eszter Vitorino-Füleky, senior responsible investment advisor at Kempen, suggests there is as yet little evidence of ESG investment to date triggering any decisive move towards active management and while there are signs of such a move when it comes to what might be termed the more hardcore SDG-based investment, “there is no strong evidence of this yet”.
Van Weelden at Indefi admits the evidence is “somewhat under the radar at the moment” that any institutional switch is taking place but he does sense some movement in attitudes. “Some large institutional investors have started to allocate towards impact,” he says. “In the interviews we conducted it became very clear that this is being planned by a wider group of pension funds.”
Peter Sleep, senior investment manager at 7IM, suggests that while the jury might be out of the actual evidence of any switch, the point regarding the ability of active to better spot forward-thinking trends compared to the more rear-view mirror approach of passive investment is “well made”.
“Active managers have a chance to win back market share if they can show they precipitate change on ESG, he says. “They do not have to be that innovative or forward thinking, but they do need to stop treating ESG as a cost of doing business and start to see it as a competitive edge.”
The point here is passive is very much data-driven and, for obvious reasons, this data is historic.
“In my opinion, the approach of the investment industry to ESG is often poorly thought through, contradictory and in many cases next to meaningless,” he adds. “Many companies are greenwashing their funds to make them commercially attractive without putting in much resource or changing their own behaviour.”
This should not be the case. Klijnstra’s comment in the summer was that investors had an active role to play in “defining the long-term outcome of the company by having a continuous dialogue with management on long-term strategy and ESG”.
“As a sustainable investor we have a role in keeping management focused on the long-term strategy,” he adds. “Engaging by having a continuous dialogue, influencing management and doing proxy voting is done with the aim of driving positive change.”
In comparison, passive investors don’t engage in the same way. “Even if a passive provider offers engagement services related to ESG it will not be an integrated approach based on the long- term potential of the business,” he added. “It is a standalone activity in that case and will be very much rule based and focused on policies and incidents. It is not principle-based and does not address the strategic challenges faced by a company’s management.”
But Sleep remains sceptical that active is fulfilling its role on the other side of this coin. “It is very hard to see that the approach of active managers is differentiated from passive at the moment. In my present role I speak to a lot of active equity managers and I hear the term ‘engagement’ all the time, but what does ‘engagement’ mean? I see very little by way of outcome, with maybe one or two noble exceptions.”
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