Wind turbines are shown on June 15, 2021 in Papalote, Texas
Demand for sustainable investment strategies is shifting from avoiding harm to actively doing good © Getty Images

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Passive providers will struggle to gain traction in some strategies focused on good environmental, social and governance (ESG) outcomes, because active managers have an edge in the area of stewardship, according to some analysts.

Despite record inflows into passive ESG products, some see challenges ahead as the demand for sustainable investment strategies shifts from avoiding harm to actively doing good.

So-called negative or exclusionary screening, which excludes certain companies, was the best-selling passive ESG strategy until 2018, according to Mark McFee, director at Broadridge Analytics Solutions.

However, he argued that this strategy had since been outsold by strategies with positive screening and by sustainable thematic funds with a more narrow focus.

This article was previously published by Ignites Europe, a title owned by the FT Group.

He pointed out that while passive investors can engage with the companies they invest in via shareholder voting, that active managers had additional leverage because they could choose to “walk away”.

The streamlining of standards and terminology may eventually benefit passives and their indices but “at the moment a significant portion of ESG investments require subjectivity on the part of an asset manager to express a vision of a more sustainable future and satisfy increasingly stringent investor demands, giving active managers the edge”, McFee said.

Data from Refinitiv Lipper show active strategies accounted for 83.7 per cent of all European ESG-related assets under management and 74.1 per cent of flows in 2020.

Detlef Glow, head of Europe, Middle East and Africa research at Refinitiv Lipper, said active managers could also add value to ESG-related strategies by “interpreting trends in the underlying data and from their due diligence interviews”.

In addition to this, he said active managers are able react straight away when a controversy arises, such as the problems at Boohoo last year.

In contrast, ETFs and passive products have to wait until the index committee reviews its index constituents before it can implement changes and this often happens only semi-annually, according to Glow.

However, Hortense Bioy, global director, sustainability research at Morningstar, warned that it would be a “mistake” to assume that passive funds do nothing on the engagement front.

“Providers of index funds and ETFs may not engage with every holding they own, but they have dialogues with a large number of companies to promote best practice on a variety of systemic ESG issues, such as climate risk and board diversity,” she said.

Large passive fund managers, including BlackRock and Vanguard, have stepped up their engagement efforts in recent years and are “increasingly voting against management when engagement fails to effect change”, added Bioy.

She said data showed that passive ESG products were gaining increased traction among investors.

According to Morningstar data, flows into European ESG ETFs amounted to €25.8bn in the first quarter of 2021, four times the €6.2bn recorded in the same period last year.

Deborah Fuhr, managing partner and founder of ETFGI, said there was a “misunderstanding” that ETFs do not vote. She said governance professionals at larger fund managers would vote the same way at shareholder meetings for holdings in ETFs as for those in active funds.

Fuhr said ETFs had seen consecutive net inflows on a monthly basis for almost two years because active funds were “not delivering on performance and their fees are much higher”.

She pointed out that active impact strategies were not always actively managed and added: “Even an index can invest in companies looking to do good . . . It’s not like active has some magical method that can’t be defined in an index.”

However, Bioy said: “Limited impact-data availability remains a challenge for index-tracking products.”

Amin Rajan, chief executive officer of Create-Research, an asset management consultancy, agreed that there had been a “pronounced rise of stewardship” at passive providers over the past two years, in reaction to the perception that they were “lazy owners” of the shares they were forced to own according to the rules of the index. He said they had “a strong incentive to exercise greater engagement to boost the quality of beta assets”.

However, he added that active managers had a distinct advantage because they tended to have more concentrated portfolios.

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