Some investors believe that as 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 benchmark’s. Passive strategies can incorporate ESG factors, however.

Overview of passive strategies

This publication covers passive investments that seek to match the performance of a market or a section of a market by closely tracking the return of a capitalisation-weighted index. There are a variety of methods that are used by passive investments to replicate an index.

  • Full replication methodology requires buying all the constituents of an index.
  • Partial replication methodology (also known as stratified sampling) sees the investment manager invest in a sample set of constituents of an index and adjust their weights so that the fund matches the index on characteristics such as market capitalisation and industry weightings. While this can lower transaction costs, it can increase tracking error as the sample may not closely follow the index. This approach is often used when the index consists of many stocks, and/or stocks with low liquidity.
  • Another approach uses derivatives to track an index. (Full replication and partial replication approaches may use derivatives to some degree.

Passive investments that track an index will buy and sell stocks periodically to reflect the changes to the underlying index.

Enhanced passive

Where the investment objective of passive investments is to match the performance of a capitalisation-weighted index, the objective of enhanced passive investments is to either reduce the downside risk relative to a capitalisation-weighted index or beat its performance. This is achieved by using the index and its constituent weights as the core of the portfolio, and engaging in restricted active strategies, including divesting certain securities, adjusting the weights of constituents and trading derivatives.

With the rising popularity of passive strategies, PRI signatories are keen to understand if integration techniques can be applied to these investments.

One approach is to reduce the ESG risk profile or exposure to a particular ESG factor by tracking an index that adjusts the weights of constituents of a parent index accordingly. Funds that use a partial replication approach can also exclude companies with high ESG risk or low ESG ratings. Often these benchmarks use portfolio optimisation techniques to minimise tracking error.

Additionally, integration techniques can be applied to enhanced passive strategies. As enhanced passive strategies can make active investment decisions such as adjusting index constituent weights and excluding certain stocks altogether to lower downside risk or outperform the benchmark, managers can integrate ESG factors into these strategies.

Responsible investment indices and custom benchmarks

The market for responsible investment indices has grown steadily since the first were launched 25 years ago, and most major index providers now offer them. Although the majority exclude companies – either based on specific, absolute factors (e.g. involvement in certain products) or by assessing all companies relatively and excluding the worst (a best-inclass approach) – some re-weight constituents.

  • The MSCI Global Low Carbon Target Index reweights the constituents of its parent index to reduce its carbon exposure and deploys portfolio optimisation techniques to minimise tracking error (see case study).
  • The iSTOXX SD-KPI indices identify the three ESG factors that are considered most relevant to business performance for each index constituent, and overweight or underweight them based on an ESG score (see case study).

As it can be difficult for an investor to find an off-the-shelf responsible investment index that matches their policies and strategies, some create custom benchmarks, either internally or through service providers, to incorporate their specific ESG criteria.

For example, Northern Trust Asset Management collaborated with MSCI to create the MSCI Emerging Markets Custom ESG index. Starting with the parent MSCI EM Index, the customised version first screens out companies that do not comply with the UN Global Compact Principles, are involved in the production or sale of tobacco products, or are involved in the production of controversial weapons. The second screen excludes majority held companies with a controversial board composition.

As well as being used for passive investments, responsible investment indices can be used as benchmarks for active investments, allowing an active manager to select stocks from an investment universe with a lower initial ESG risk profile than the parent index. Responsible investment indices can also encourage constituent companies of the parent index to increase the standard of their ESG disclosures.