By Toby Belsom, Director, Investment Practices
Passive investing is often presented as a win-win scenario for asset owners – cheap, consistent and does what it says on the tin. The effectiveness of this argument among institutional and retail investors is reflected in the growth of passive funds, which now represent at least 45% of S&P 500’s assets. It will be interesting to see if the recent market volatility puts a break on some of the growth in passive strategies.
Market structure has also meant that the management of passive products is concentrated in a small number of leading managers. These managers now often represent the largest shareholders in many of the largest listed companies. These changes have far-reaching implications for the relationship between managers, shareholders and asset owners. The combination of ESG and passive strategies has also led to an increasing diversity and AUM invested in ESG index products.
These trends have significant consequences which affect many of our signatories. As a result, the PRI has undertaken a signatory survey to identify some of the key issues facing asset owners, managers and service providers in these areas. We have recently published the findings of this consultation alongside a series of case studies. These highlight a range of issues and questions around the development of ESG indices and the role passive managers can play as active owners.
Survey – key findings
This box outlines some of the key findings from the survey of institutional asset owners and asset managers. The full report is available here.
How can ESG issues be effectively and transparently integrated into index construction?
Allocating to a passive investment strategy still requires an active decision around index and performance benchmark selection. This decision might include incorporating ESG factors into the construction – or selection – of these indices or benchmarks. Here, the survey highlighted challenges around index/benchmark complexity and comparability, and index and fund transparency.
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. Though some are particularly relevant in the development of ESG indices or benchmarks. Survey participants also discussed the potential role of regulators could – or should – play in designing and constructing benchmarks.
How can passive fund managers improve their stewardship of assets?
There were also questions around the role passive investors should or could play as active owners. Respondents wanted to see more collaborative engagement, while resource constraints – particularly among smaller asset managers and owners – were seen as limiting progress.
Participants identified the need for asset owners to encourage the largest passive asset managers to undertake corporate engagement. Divestment was discussed as a unique challenge for passive investors.
For an increasing number of signatories – who are committed to the PRI’s Principles I and II, as well as allocating assets to ESG index products or other market cap-based indices – these are issues that need exploring.
The findings highlighted two areas that gained most interest and deserve more action:
1. Improving disclosure and transparency
Asset owners flagged issues surrounding the construction of ESG index products and benchmarks; namely their complexity, lack of transparency and comparability. These issues are not unique to passive strategies but are particularly acute as ESG indices often include a diversified list of companies and are constructed using complicated algorithms. Product providers need to adopt and develop standards such as the EU Taxonomy, which outlines a clear framework for the delivery of improved transparency.
2. Improving stewardship
The consultation also highlighted issues associated with stewardship that are particularly relevant to asset owners and managers allocating to or implementing passive strategies. A combination of this feedback and the PRI’s Active Ownership 2.0 programme – which prioritises outcomes over process, and common goals over narrow interests – provides some important messages for stewardship among passive investors.
Asset managers with substantial AUM in passive strategies play an integral and increasing role in the governance of corporations. Feedback from the survey indicated that, as a minimum standard, these leading asset managers should expect to be responsive to the engagement objectives and aspirations of clients, transparent about the results of those efforts, and to play a critical role in collaborative engagement.
As universal owners with broad diversified portfolios, these managers and asset owners should have a strong incentive to engage on issues which have systemic implications across the real economy – governance, climate change and human rights.
Engaging on systemic issues requires a different approach to engaging directly with corporates. Unlike active managers, who can change their portfolio constituents, passive investors are generally committed to an index and its constituents. However, as users, they may be able to influence how it is constructed. This is being explored by global financial regulators. The latest example being the FCA’s current consultation on a proposal to require commercial companies with a UK premium listing to state whether they comply with TCFD recommendations. Premium listing being a requirement for FTSE 100 membership means this will influence constituents going forwards. Why shouldn’t internationally accepted standards – such as the TCFD recommendations, a public commitment to the Paris Agreement or alignment with OECD Guidelines for Multinational Enterprises – be considered as a threshold for index inclusion?
For the continued growth of ESG passive markets, products need to be transparent and comparable. Passive managers need to ensure they are not seen as lazy owners and are instead engaging corporates or regulators on systemic issues that cut across markets.
This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.
Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.
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