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Commentary: Active beats passive in promoting sustainable development – Pensions & Investments

Impact team
Written by Impact team

Commentary: Active beats passive in promoting sustainable development  Pensions & Investments

Growing investor concern about climate and societal crises have contributed to the burgeoning demand for sustainable investment funds that take into consideration environmental, social and governance factors.

According to Morningstar Inc., sustainability funds attracted $20.6 billion of new assets globally in 2019, almost four times higher than the previous year. That should be a positive development, as more capital should, in theory, be channeled into helping resolve some of the world’s greatest challenges. However, this may not necessarily be the case as not all sustainability funds are created equal.

The biggest differences occur between active and passive funds, and more specifically, in how they assess ESG factors, and how they engage with companies. Passive investing typically uses quantitative ESG data procured from third-party providers to either exclude companies or tilt a portfolio toward more “sustainable” companies, or a mixture of both. Active investment involves picking individual stocks and bonds based on an assessment of their underlying fundamentals and either uses qualitative or quantitative ESG analysis, or often both.

Many questions remain about the validity of ESG metrics, including a lack of standardization in the data, and the overall scoring methods being used. For example, in 2018 three well-known and highly regarded services came up with completely different ratings for Tesla Inc. on ESG issues. FTSE Russell rated Tesla as the worst carmaker globally based on its metrics, MSCI Inc. ranked it the best and Sustainalytics was roughly in the middle. Moreover, it is common to find that the top-rated businesses on ESG issues also tend to be larger, developed market companies, suggesting the data are skewed to large-capitalization firms that have more formalized policies and more transparent disclosure.

Using quantitative ESG data can be beneficial in some circumstances, but placing too much emphasis on “ESG by numbers” can be a risky strategy. It also is unlikely to fulfill the desired outcome of shifting capital toward more productive purposes. A quick glance at the constituents of the Dow Jones Sustainability World index, BlackRock Inc.’s iShares ESG ETFs or the FTSE4Good index series, reveals the familiar names of Apple Inc., Google’s parent Alphabet Inc. and Bank of America Corp. These businesses offer useful products and services, but are they really the most “sustainable” businesses?

To invest in the highest quality companies, that both contribute to and benefit from sustainable development, there needs to be room for qualitative judgments, on more nuanced areas such as:

  • Are the products and services useful and making a valuable contribution to society?
  • Is the company genuinely trying to improve its approach to sustainability rather than just greenwashing?
  • Is the company able to navigate sustainability headwinds and tailwinds (e.g., changing consumer preferences or regulations)?
  • How is the company’s corporate governance? In other words, how does it treat various constituents — shareholders, employees, customers?

It is not easy to find answers to these questions in ESG data alone, and it is difficult to ascertain when investing in hundreds and sometimes thousands of companies. Genuinely active investment managers, with high active share and more concentrated portfolios, should be better placed to assess these gray areas and therefore make more considered and conscious judgments.

Engagement is another important difference. For passive funds, the approach to engagement can be limited by the breadth of their portfolios and is often conducted by groups that are separate from the investment team. In these cases the highly diversified nature of passive funds can work against effective stewardship. Long-term active investors that hold stocks for five years or more have the opportunity to build relationships over time, helping them to influence corporate policy and encourage better practices.

Proxy voting is another component. Research finds that active investors are more likely to hold management to account by voting against them on proxy ballots, vs. passive investors that are more likely to vote in line with management. Even worse, recent research from Morningstar found a number of large passive investors have repeatedly voted against resolutions related to the environment or climate change at annual shareholder meetings even as they publicly call on companies to consider climate risks.

Investing is a personal decision, with different, legitimate reasons for pursuing different strategies. When it comes to understanding how best to promote sustainable development, if that is an important consideration, investors — institutional and individuals alike — need to weigh whether cheaper and simpler passive or more expensive and research-driven active funds are the better investment vehicles. If the investor goals are to meaningfully shift capital toward more productive and sustainable companies, then genuinely long term, actively managed strategies employing both quantitative and qualitative research as part of their investment process are the best choice.

Lorna Logan, based in Edinburgh, is an investment analyst in the sustainable funds group at Stewart Investors. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I’s editorial team.

Source: pionline.com

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