27 Jun 2019

3 reasons why passive is becoming the #1 choice for ESG


Question: if you want to invest sustainably, should you go with an active manager or an index fund?

The answer depends on who you ask.

You might hear that active managers are best-placed to implement sustainable strategies – such as environmental, social and governance (ESG) – because they can make considered and conscious decisions to buy or sell companies, based on their behaviours.

Or you might be told that index funds can achieve the same results (or better) in a rules-based way for a fraction of the cost.

It’s become increasingly important to get an answer to this question. Sustainable investing is in the process of going mainstream – inflows into ESG ETFs alone grew by 45% in 2018, and by another 50% by the middle of June this year.1

As the money invested in sustainable strategies rises, the stakes get higher, and the more investors need to understand which approach works best for their goals. They’re faced with a choice, on which could rest the makeup of their portfolios, and indeed their contribution to a sustainable future for the planet.

In this article, we outline three factors that we believe support an index-based approach for ESG investors in 2019 and beyond.

1. Better data means ESG indices match key sustainability goals

There are very few ESG investment objectives that can’t be achieved using the right indices built with the right data. One major biproduct of the trillions’ worth of money that’s flowed into passive funds over the past decades is the increased investment by index providers into the quality, innovation and breadth of their range.

Take indexing giant MSCI for instance. The company employs 185+ dedicated ESG analysts, provides ESG ratings for over 6,500 companies, and runs over 1,000 equity and fixed income ESG indices. With MSCI’s 40 years of experience collecting, cleaning and standardising ESG data, even active managers rely on their data to create sustainable strategies.2

Thanks to these improvements in data quality, indices available today reflect all sorts of ESG policies: from negative-screening or exclusions, to implementation of specific values, selection based on global ESG ratings or carbon ratings, and alignment with the UN’s ‘Sustainable Development Goals’ (SDGs). All these varied objectives can be codified in indices.

Some ESG benchmarks can be used as portfolio cores, and can easily substitute traditional market-capitalisation weighted indices, with limited tracking error. Others are more values-oriented or based on sustainability themes, and are therefore used as diversifiers, whenever implementing those convictions justifies a higher tracking error.

Overall, better indices mean better ways to invest sustainably in a consistent, targeted, rules-based way – an important consideration for ESG investors looking to make lasting positive change.

2. Passive makes ESG investing scalable

One other aspect of sustainable investing is a focus on ‘impact’, which means assessing an investment’s social or environmental effect alongside its financial return.

The concept of impact investing is often associated with private and community investing, achieved through private loans and private equity. Yet while active funds are well-placed to invest in private debt and equity, the same principles that support investing in private assets – intentionality, additionality, measurability – are also found in publicly listed assets.

Not only that: the liquidity of these listed assets – and of ETFs invested in them – brings scale and scalability, which are missing from private investing. It enables larger amounts of capital to get to work, and this adds up to private impact, especially when indices are designed for specific sustainable goals.

Examples from Lyxor include indices that invest in alignment with those of UN SDGs, including climate action , water , clean and affordable energy and gender equality , or that invest in companies with a rising ESG trend – and not only the best-rated ones, as we believe it is more impactful to reward companies actively making changes.

3. Passive managers can have an active voice

One concern among investors assessing active and passive strategies for sustainable investing is shareholder engagement: how can a passive investor hold portfolio companies to account?

Some passive managers, including Lyxor, have tackled this by setting up voting policies like an active manager. These policies and voting records are public, as we are accountable to our fund holders. Lyxor’s shareholder engagement policy also involves a direct dialogue with companies to communicate expectations, for example with respect to governance.

Lyxor votes when we retain over 0.1% ownership in a company, and last year we voted negatively for 22% of the resolutions in general meetings we participated in, which is slightly above industry average. From an AuM perspective, we voted on €13.8bn of equity positions in 2018.3

Therefore, it is possible to exert influence and encourage positive behaviour through passive investing – if that investment is with an ‘active’ passive manager.

It all boils down to choice

The combination of better data on ESG, the scalability of index-based ESG investing, and increased engagement of passive managers with the companies they hold means investors can comfortably look to passive ESG strategies to make a difference in their portfolios.

But whether you favour an active or passive approach, one thing is clear. The change in mindset of investors – particularly those of the “millennial” generation who can be as old as 38 – and indeed, the change in their day to day practices such as purchasing decisions based on the sustainability profile of their preferred brands, means that ESG investing is here to stay.

In the same way that ETFs caused an unquestionable shift in the investment landscape, we’re delighted to see a similar shift towards better, greener portfolios. And fortunately, choices abound for investors seeking to reflect their personal values into their investments.

1Source: Lyxor International Asset Management, as at 17/06/2019.
2Source: MSCI ESG Research as of November 2018. Includes full time employees and allocated staff performing non-investment advisory tasks.
3Source: Lyxor International Asset Management, as of 31/12/2018.

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