Passive ESG funds are getting more and more popular, but questions remain over how sustainable they are.
One of the key themes of March’s PLSA conference in Edinburgh was the growing onus on trustees to comply with responsible investment standards. Factoring in the material risks of climate change is increasingly seen as a fiduciary duty, as the updated rules for the Statements of Investment Principles highlight.
At the same time, a growing number of investors are seeking exposure to the asset class by investing passively. Indeed, more than half of European investors plan to implement their ESG
strategy over the next five years using predominantly passive funds, a survey has discovered.
Yet a detailed look at passive strategies for European equities shows that such an approach does not always create a sustainable portfolio, highlighting the need for pension schemes and their asset managers to employ engagement specialists.
How green is your passive fund?
The universe of passively managed sustainable funds has increased exponentially. Morningstar lists 113 ESG-compliant ETFs in the UK for investors to pick from, almost 70% of which have been launched in the past two years.
One advantage of this mushrooming market is that the average cost of newly launched funds has plummeted to 24 basis points from 64 in the past 13 years. Most of these new sustainable equity
passive funds pursue a best-in-class approach, where better performing firms have a higher weighting in the benchmark index. But overall, they continue to have a relatively low tracking error to a purely market-cap based index fund.
This raises the question of how sustainable those funds truly are, particularly when it comes to climate change. Virtually every European equity ETF (with the exception of ex-fossil fuel funds) lists Total, a French oil and gas firm that booked a $200bn (£152bn) profit last year, as one of their main holdings.
In some cases, it is even one of their top five positions. This highlights the problem for passive investors who want to pursue not just financial but also sustainability targets. The commonly pursued best-in-class approach selects for each sector the firms which perform better on a relatively basis.
By maintaining a similar sector allocation to the standard index, the firms offering the funds aim to replicate the key properties of the index in question and ensure a relatively low tracking error.
Trustees do, after all, have a fiduciary responsibility to ensure that the performance of these funds does not lag too far behind that of conventional indices. But to what extent does an investment in an oil refinery or a petrol station operator contribute to reaching the two-degree target stipulated in the Paris Agreement?
With a market cap of more than $100bn (£76bn) in August, Total is a heavyweight in the Stoxx 50 index. Similarly, oil giants Shell and BP take a prominent place in the FTSE100 and are therefore hard to avoid for passive investors who are cautious about significant deviations from the conventional index. More sustainable alternatives, such as Danish wind turbine maker Vestas, have a much smaller market capitalisation.
Controversy despite strong ESG scores
The market cap dilemma allows the impression that many fund providers and end-investors prioritise a lower tracking error to traditional indices over sustainability. This is reinforced by
many funds specifically referring to environmental targets and still investing in fossil fuels. This is where engagement comes in with investors leveraging their voting power to make energy companies change their practices, set emission-cutting targets or invest in cleaner forms of power.
We cannot just stop pumping oil out of the ground, but we could use the huge profits such companies generate to fund the decarbonisation of the economy.
While sustainability has rapidly moved up on investors’ agenda, growth in the investment universe is slow. Some firms have developed indices with weighting towards energy consumption, for example, rather than market cap.
But firms such as Total are too big to fully exclude them. Similarly, Royal Dutch Shell and BP are still the number one and number three firms in the FTSE100 in terms of market cap, making it harder to fully divest from them. Another reason why engagement is such an important part of sustainable strategies, whether they are active or passive.
Oil giants are in low carbon indexes, but could they soon fall out these benchmarks? The crisis linked to the Covid pandemic has the benefit of hitting energy companies hard with the price of oil having fallen into negative territory at one point.
Focus on momentum
One way of honouring the sustainability approach despite the inclusion of controversial sectors could be a relatively higher weighting of firms with ESG momentum, that can demonstrate progress in sustainability.
A good example of a best-in-class strategy is one that includes shares in firms that can demonstrate a positive trend towards improved ESG profiles. Those companies that have a robust ESG profile relative to their sector, as well as a positive trend in improving that profile.
It still raises the question whether it is justified to include Total as second biggest holding. The fund pledges to exclude firms from ESG sensitive sectors whose products or activities could have a negative effect on society or the environment. While this refers to alcohol, tobacco, gambling, nuclear energy and weapons, it does not exclude fossil fuels.
One benefit of the focus on momentum is that it offers more potential for value appreciation, given that it does not just include the most sustainable and therefore often expensive companies.
A recent Morningstar study lists Total, Shell and Repsol as some of the firms making the most progress in cutting emissions. But Morningstar also points out that despite these improvements, all firms fall short of aligning their CO2 output with the Paris Agreements.
A more targeted-oriented approach towards sustainability could be the inclusion of the United Nations’ 17 Sustainable Development Goals (SDGs). Several big asset managers, including Robeco and iShares have pledged alignment to the SDGs for some of their fund offering. Some firms go as far as excluding oil giants and car manufacturers altogether, but so far, this remains the exception, rather than the rule.
This is partly because excluding fossil fuel firms and car makers would shrink the investable universe in European equities to 365 firms. Moreover, oil continues to be a cornerstone of the global economy for the time being and oil companies have offered relatively high dividend payments. But some investors are starting to price in the costs of climate change and are willing to
make a conscious decision not to take part in profits from certain sectors.
Trustees in the UK will increasingly have to brace themselves for the fact that passively investing in ESG cannot be seen as a shortcut to sustainability, argued Russel Pictot, trustee chair at HSBC Pensions, at this years’ PLSA conference in Edinburgh. “I don’t think it’s acceptable anymore for trustees to invest in a passive indexation strategy and take a passive approach to stewardship,” he said.
Studies show that sustainable investments do not tend to have a negative impact on returns and reduce reputational risks.
Avoiding a particular sector can nevertheless lead to a dramatic reduction of the investable universe and would require significant balancing skills. Many institutional investors have good
reasons not to exclude certain sectors. Being overweight on solar energy, for example, would not have necessarily been overly profitable.
Moreover, ESG investment should not result in neglecting the importance of risk management, after all, the investment should also be sustainable from a financial point of view. But neither should it be in the interest of ESG investors if the term sustainable investment has turned into a mere marketing concept with little impact on the portfolio constriction.
With that in mind, the inclusion of energy giants in funds that are promote for their environmental standards continues to appear misplaced.
This is an edited version of an article by Patrick Eisele that first appeared in portfolio institutionell, the German sister publication of portfolio institutional.