Some investors have the mis-conception that because a manager cannot make active investment decisions in passive strategies, ESG factors cannot be integrated in passive investments as this may cause performance to deviate from the benchmarks. This mis-conception stems mostly from the use of negative screened strategies and even though screening is still the most common approach globally to the incorporation of ESG factors into externally managed passive portfolios, new data sources and techniques means that other ESG strategies are increasingly adopted including:
- Active ownership: As with active investors, passive investors can at a minimum use their voting rights (if they hold equity) and engage with investee companies on ESG issues either individually and/or collaboratively, with the objective to encourage better practices or disclosure or to improve ESG risk management. This may involve ensuring that the passive manager has robust share voting guidelines and engagement policies (e.g. HESTA, Australia) and/or appointing a specialist engagement and overlay provider (e.g. National Pensions Reserve Fund of Ireland). An issue to be aware of that may impact proxy voting in passive strategies in particular is stock lending, which tends to represent a larger proportion of the overall income on passive funds when compared with active funds. The potential implication of this is that passive managers may be incentivised not to recall stock to vote at AGMs. Guidelines are available from PRI and the International Corporate Governance Network.
- Integration / Enhanced passive management. Investors can increasingly take advantage of a variety of ESG-screened investment indices offered by major index providers such as FTSE, Dow Jones, MSCI and national stock exchanges such as the JSE. These approaches use ESG scores to tilt (over- and underweight) portfolio constituents relative to a benchmark and then use optimisation methods to ensure the portfolio tracks the underlying benchmark (i.e. to reduce tracking error).
- Thematic investing: Applying the thematic approach to passive investments is intended to capture long-term opportunities from structural trends such as environmental change, demographic shifts or technological advances. Companies from the parent index or universe with high exposure to a specific trend or activity are incorporated into the thematic index. Examples of themes include water (for example, the S&P Global Water Index). These indexes are then used to develop various passive financial products, often structured as ETFs, for retail or institutional clients.
When selecting fund managers, pension funds should pay attention to the methodology, rules and accuracy of chosen screens. If there is no off-the-shelf responsible investment index that matches the pension fund’s policies and strategies, it is possible to create custom benchmarks to incorporate their specific ESG criteria. Have the conversation with your passive strategy provider and ask them to come up with viable solutions.
Breakdown of types of ESG techniques applied to passive strategies.
Source: Results of the 2019 PRI Reporting and Assessment Framework. (Note: Respondents could only select one option).