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ETFs and ESG engagement: Passively active

16 Nov 2020

Regulatory pressures on stewardship have evolved, with passive investors feeling the pressure to engage. How have ETFs evolved to accommodate to this challenge?

Passive investing is evolving. It has had to. Regulators have made it clear that index investing and ETFs do not exempt institutional investors from their responsibilities as shareholders. So, when it comes to stewardship, even passive investors have to be active.

The beneficiaries of this ruling are the environment and society. Billions of pounds have poured into environmental, social and governance (ESG)-led passive strategies this year as investors see that ESG considerations have never been more material to managing risk and long-term sustainable value creation.

Indeed, $32bn (£24.8bn) was invested in ESG-focused exchange-traded funds (ETFs) in the opening six months of the year, consultancy ETFGI says, more than three times the $9.8bn (£7.6bn) recorded in the first half of 2019. Meanwhile, $250bn (£194.3bn) flowed into sustainable index funds during
the same period, according to Morningstar.

From a sustainable point of view, this is good news as there is always an opportunity to advocate for more, whether that is higher governance standards, a more diverse management team or better climate management and disclosures.

In indexing, the value of stewardship is clear. “Passive investors need to be active because they are forced owners of companies with significant ESG concerns,” says Ian Burger, head of corporate governance at Newton Investment Management.

This point is echoed by Mette Charles, senior investment research consultant at Aon, who says that when it comes to ESG, even passive investors need to be “agents of change”.

Yet this is easier said than done. Index managers are adopting some of the practices enjoyed by their active peers, but the influence they can exert over corporates is not as strong.

“Given the weight of money that sits behind passive approaches, we need passive managers to be active to drive positive change. So, it has to happen,” says Tim Manuel, Aon’s UK head of responsible investment. “But we all acknowledge that some of the levers available to passive managers are limited.”

These limited levers mean passive managers typically cannot sell a company that is not responding their concerns as a shareholder. It must continue holding the stock despite the fund’s ESG focus.

There are index funds that do use divestment as part of their strategy, such as Nest, but this is the exception rather than the rule.

“Many passive investors do not have the luxury of the ultimate sanction,” Burger says. “If a company has a significant ESG concern, active managers can sell it or avoid holding it in the first instance.”

Marta Jankovic, a director in BlackRock’s Investment Stewardship team, believes that index investors, precisely because they cannot sell, are uniquely positioned to advocate for business practices which are consistent with delivering long-term sustainable financial returns. “It is a misconception that index managers do not have the tools to drive change because they cannot sell stocks that may not fulfil their sustainability expectations,” Jankovic says.

“Through engagement and voting we express our views as shareholders and help drive long-term change within companies,” she adds. Through engagement we build an understanding of a company’s approach to governance and its sustainable business practices. We also communicate our views publicly, so companies know what we expect of them.”

For Jankovic, the absence of the ultimate threat of divestment will not impede the growth of the ESG-focused index market. “Index fund managers continually engage to drive long term change. This is the value of patient capital,” she says.

In the passive world, this is the way shareholders should push for change. The index managers that have the power to sell stocks to improve the ESG performance of their index fund could leave investors disappointed. “If you are a passive manager, it is expected that the tracking error to your index is minimal,” Charles says. “If you start divesting you run up against that problem. Divestment, unless you are prepared to compromise on the tracking error, is not an option,” she adds.

So, it is for good reason that the majority of passive managers do not have the discretion to sell stocks. But there is another positive to being a forced owner. “There is also this angle that divesting takes you away from the table,”

Jankovic says. “As an index holder you have regular dialogue with management, and that engagement provided by your holding gives you influence.”

Come together

For smaller investors, regular dialogue with corporates can be difficult, even when an active manager can dangle the ultimate threat of selling the stock above a chief executive’s head. What could help, active and passive managers alike, is several shareholders increasing their influence by working together.

“Collaborative work is an important escalation tool,” Burger says. “A critical mass of investors could help further a debate or influence change at the corporate.”

But he fires a warning that although strength in numbers could improve the chances of creating change within a corporate, such success must be earned. “Do not underestimate the time, energy and resources required to effectively collaborate with other investors,” he adds. “It is a significant commitment over and above one-on-one engagements.”

Jankovic also sees value in a different collaboration, with BlackRock being a member of several investor-led initiatives, including Climate Action 100+. “Collaboration groups are useful on policy-related issues such as transparency and disclosure, climate risk, diversity or enhancing shareholder rights, but BlackRock’s stewardship activities are focused on direct dialogue with companies, as we have the largest team in the industry,” she says.

There are so many shareholder pressure groups around that Charles believes there is no excuse for passive managers not to engage with companies in their index. “The expectation is that if managers, no matter how small, are offering passive investments they should offer something on the engagement and collaboration front as well,” she adds.

Although being part of some of these investor initiatives, BlackRock’s stewardship activities are focused on direct engagement with companies and voting at shareholder meetings. “It is in the long-term interest of our clients for us to establish a dialogue with companies, so we have an opportunity to share our views on topics that we think are material for their long-term performance,” Jankovic says.

“It is because we are long-term investors through our index portfolios that we can build the trust that supports this continued effective dialogue.”

A powerful sign

There is a tool that is the ultimate way of showing your dissatisfaction with a company’s ESG performance: voting.

Through expressing their views in this way, shareholders are sending a big signal to management, Jankovic says. “We have that option; it is a strong one.” But Jankovic warns that you should not exercise such an action lightly. “Engagement comes first for us,” she says. “Voting is the mechanism we can use if engagement has not, over a significant period of time, led to change.”

For Burger, this is all part of the engagement process. “Voting is a useful tool in formally recognising concerns. Can it effect change? Yes, it can,” he says.

But this may not be the case across the whole portfolio. Those holding US stocks will not have the power to block a board appointment. “Shareholder votes are votes of confidence in US companies,” Burger says.

Even in the US, such action can show huge dissatisfaction. “Voting against management is a tool in the toolbox,” Charles says.

There could be a feeling that if shareholders are voting against management on a particular issue that engagement has failed. Jankovic does not agree. “While voting sends a strong signal to management it does not mean it’s the end of the road. On the contrary, it can lead to an escalation of the issue at board level.

It is not closing a door; it is about sending a strong signal of concern about something you find important as a shareholder,” Jankovic adds.

Manuel goes further by explaining that a vote should not be taken at face value. “A vote against management needs to be considered in the context of the overall objective that a passive manager is trying to achieve before deciding if engagement has failed,” he says.

Spending time understanding the unique circumstances of the company is part of engagement, Burger adds. “To be successful in an engagement, one needs to understand what the circumstances of the company are.”

But there could potentially be a silver lining to blocking the re-appointment of a director in that their replacement may be more willing to engage with investors.

The right path

ESG is a broad church and there are many different changes sustainability-focused investors want to make to the world, from ending climate change to abolishing pay inequality and raising the standards of human rights.

To help bring clarity here, BlackRock has developed a framework across all asset classes that helps match investors to their sustainable objectives. The framework could help investors find index strategies that focus on themes, exclusions, fixed income or are tilted towards high ESG performers.

“With sustainable investing there are different pathways for investors,” Jankovic says. “Our framework is a good way to approach the topic because there is no one-size-fits all solution.”

Despite the explosion in their number, funds tracking indices with an ESG angle are still being perfected. The first generation were blighted by a lack of comprehensive data needed to tilt them towards a particular issue, but they are improving, Manuel believes.

“The second-generation indices attempt to be more forward looking in how they are constructed,” he adds.

“They try to incorporate information that will highlight the companies which will have better ESG characteristics in the future or are better positioned to manage through the low carbon transition. That has been a big development in the passive market.”

And developments such as this are needed to continue to attract and adequately manage sustainable passive mandates. The ruling on stewardship and passive funds will clearly help boost the ESG performance of such vehicles. Passive investing is now playing a bigger role in creating a more equal society and helping the world transition to a low carbon economy. A welcomed development.

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