The active versus passive debate in the asset management industry has become quite heated lately. Some industry professionals find a combination of actively managed funds and products that track an index work well together in an investment portfolio, whilst others have strong opinions for or against one or the other. Recently an extra dimension was added to the mix: can socially responsible and innovative investing really be done passively, with for example an ETF?
The answer in a word is yes.
These days, systematic screening and exclusions can be easily implemented in passive instruments. The one thing you need, are data that matter. In recent years, the quality of ESG data has improved significantly and this will continue to improve, especially with the increasing use of big data and artificial intelligence. The latter has led to more sophisticated and effective passive ESG strategies and to more transparency within the use of ESG criteria.
With an increasing number of investors opting for passive ESG investment solutions these days it is also important to understand how ESG benchmarks perform compared to standard market capitalization counterparts and what drives their performance.
Top-scoring ESG portfolios tend to have better risk properties than broad market-cap portfolios. The reduction of risk is material to all three ESG pillars, with governance as the most important factor for improving returns.
Adding to that, in-depth analysis indicates that sector neutrality removes ESG-driven longer-term biases. Sector-neutral ESG indices are therefore expected to perform in line with broad benchmarks. Looking at the performance development of the MSCI ACWI vs. the MSCI ACWI SRI, long-term differences are minimal and even slightly in favor of the ESG option.
Another common misconception in the financial industry is that sustainability factors cannot be taken into account in passive strategies as investments have to track the performance of capitalization-weighted indexes. Similarly, stewardship activities might be considered irrelevant in passive portfolios as the manager cannot buy and sell stocks in response to the success or failure of engagement activities.
On the contrary, in passive strategies dialogue with investee companies is even more crucial to raise awareness and influence corporate conduct on matters that can impact the economy overall, such as bribery and corruption, climate change or human capital management. In fact, stewardship activities linked to passive ESG strategies can also incentivize companies to be included in selected ESG indexes and provide meaningful insights to enhance the methodologies applied in these indices.
While the ‘classic’ ETF market in Europe over the past ten years has grown by +18% per annum, ESG ETFs have grown by more than twice as much (+42.1%).
This swift growing appetite for passive ESG investments could enable the financial industry to accelerate the transition towards a more sustainable future, taking into consideration that all stakeholders are willing to take their share. Investors will certainly benefit: in addition to their low cost, passive ESG funds are transparent. Investors know what they own and understand the process.