The challenges of passive ESG investment

It ranges from tilts based on ESG ratings – which can now be sourced from various suppliers – to specific themes such as decarbonisation. 

Yet, while the emergence of passive ESG represents an exciting development for all committed to sustainable investment, it does raise challenges that deserve greater scrutiny.

Commitment to ESG does not necessarily mean that every single investment in the portfolio must have an ESG dimension

The important question is not whether ESG can be incorporated in the context of a purely heuristic or rules-based investment style. The question, instead, is how much ESG integration an investor should seek.

Pick your strategy

In practice, we are seeing increasingly specific and complex preferences being expressed by UK pension schemes with respect to ESG equities.

Some place strong emphasis on engagement, others less so. Some focus on climate change, others are primarily interested in governance.

A minority are keen on negative screens, which can be applied very easily to either passive or active styles; a greater 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 individual priorities, which should always be at the forefront of investors’ minds, schemes should be aware of the potential limitations of passive ESG.

ESG ratings can be problematic

The scarcity and reliability of ESG-relevant data remains a challenge for active and passive managers alike. This is particularly true outside of the major developed markets.

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.

In contrast, passive providers tend to be more (sometimes wholly) reliant on third-party sources of ESG data.

Engaging for impact

Prioritising engagement may also be a challenge for passive managers.

We have observed that, if and when passive managers engage with companies, the overall exposure at a firm level to each stock influences 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, divest or short with conviction.

Check your risk profile

Investors should also take care when considering their expectations for passive ESG investments within the portfolio.

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 referencing outperformance, albeit over a short period of time, giving rise to claims about ‘ESG factors’ and some blurring of lines with the popular factor investing trend.

Investors should be clear on what they expect from these products, whether it is benchmark-like risks and returns or considerable tracking error. That can of course cut both ways, so they must also understand the potential for underperformance.

Tackling the limitations

For all its merits, passive ESG might not be the panacea initially suggested. This does not, however, mean that ESG is incompatible with the shift to passive management.

Depending on a pension fund’s beliefs, commitment to ESG does not necessarily mean that every single investment in the portfolio must have an ESG dimension.

We see UK schemes that have moved a portion of their equity to non-ESG passive or smart beta but express ESG beliefs through ESG-focused active equity managers. UK pension funds are also increasingly integrating ESG criteria beyond listed equity, particularly in private markets, as illustrated in recent publications.

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’.

Joey Alcock is director of public markets investment advisory at bfinance.