ESG & passive investment strategies

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Executive summary

The passive investment market has grown dramatically in recent years, driven by factors including low costs, evidence of the relative benefits of passive versus active investing, and new financial products such as exchange-traded funds. This trend has combined with growing interest among investors in ESG incorporation, resulting in a parallel growth in passive ESG investing.

The PRI is seeking to provide guidance to signatories and the wider market on the incorporation of ESG issues in passive rule-based investments, and regarding challenges faced by the market.

As a first stage in producing this guidance, the PRI published a discussion paper, How can a passive investor be a responsible investor? This was followed in the second half of 2019 with a consultation process undertaken by the PRI, which involved two industry events and a signatory survey. This report synthesises views expressed by participants in those industry events and respondents to the survey.

It is divided into two sections, covering:

• ESG incorporation (focused on the development of ESG indexes) and:
• Active ownership (focused on engagement approaches across passive or quant-based investment strategies, including ESG indexes)

ESG incorporation

Passive investing still requires an active decision around the choice of the passive index and the benchmark against which performance is measured. This decision might include incorporating ESG factors into the construction of these indexes or benchmarks. Here, challenges exist around index complexity, index and fund transparency, and how to compare between ESG indexes.

Data quality and availability are perennial concerns for responsible investors. Most issues – such as data availability, standardisation, reliance on voluntary reporting, and the backward-looking nature of ESG data – are not unique to the passive investment market, but were nonetheless raised by participants. They also discussed the potential role of regulators in designing and constructing benchmarks.

Active ownership

Regarding active ownership among passive investors, the need for more collaborative engagement was raised frequently by participants, while resource constraints – particularly among smaller asset managers and asset owners – are seen to be holding back progress.

Participants identified the need for asset owners to encourage the largest passive asset managers to undertake corporate engagement. They also discussed the various engagement tools available to passive investors and considered their merits and demerits. Divestment, in particular, was discussed as a unique challenge for passive investors.

Next steps

Finally, and based upon consultation feedback, this report highlights next steps for asset owners, asset managers and regulators.

Asset owner next steps include improving disclosure and reporting by asset managers, and reconsidering benchmark or index selection.

For asset managers (and service providers), they include: adopting more collaborative approaches to engagement; developing public approaches to systemic issues such as climate change and governance; ensuring new financial products are constructed and marketed in a transparent and consistent manner; promoting better corporate ESG data; and ensuring that ESG rankings and scores are based on transparent and consistent processes, and that any changes to indexes or benchmarks are accompanied by clear explanations.

Regulators, meanwhile, should encourage clear and consistent reporting, and review acting-in-concert guidelines to ensure these do not prevent collaborative engagement.

Alongside these consultation results, the PRI has published a series of case studies to show good practice in the industry.

It has also created a Passive Investment Reference Group, open to asset owner, investment manager and service provider signatories. In the coming months, the PRI intends to reflect on this consultation process and develop further guidance.