By Toby Belsom, Director, Investment Practices, the PRI
If the last 10 years saw a seismic shift in the way retail and institutional assets have moved from active to passive strategies, then the next ten might see another mass market shift as increasing pools of assets start to incorporate ESG factors into investment practice and process. These mega trends – ESG integration and passive investment – are increasingly overlapping. In response, the PRI has completed a discussion paper which kicks off a consultation process – we are looking forward to hearing a range of views before developing further guidance.
The attractions of passive funds are obvious and well-rehearsed – low costs, evidence of the relative benefits of active versus passive investing, and new financial products such as exchange-traded funds (ETFs). This heady and attractive mix has resulted in passive strategies now representing over 45% of the total market capitalisation of the S&P 500. The attraction spans to other asset classes with 25% of assets managed in global corporate fixed income funds following passive strategies.
Both asset classes are growing rapidly with little sign of deceleration. Retail and institutional investors, the media and regulators have seemingly lost patience with active managers. Their high fees and smart suits seem to be from a bygone era (I can say that, as I was one).
Another trend that has influenced the asset management industry has been the rise of ESG investing in its various forms – engagement, screening and integration. Inevitably these trends have merged, resulting in a proliferation of ESG indexes and the growth in assets managed using passive ESG strategies.
As with any developing market, the growth of ESG in passive investing is facing challenges. According to the PRI’s passive investment discussion paper, these challenges fall into two categories. Both are important for PRI signatories who have developed or utilise passive or ESG passive strategies.
ESG incorporation: Principle 1
Issues include availability and consistency of corporate data, consistency of ESG scores, complexity and transparency of benchmarks and indices, unintended portfolio skews and costs.
Active ownership: Principle 2
Issues include free-riding, familiarity with holdings, resourcing, contribution to overall portfolio performance, divestment, proxy voting regulations, stock lending and acting in concert.
The first group of challenges relates to more technical issues surrounding ESG data quality and ESG index construction. Collating ESG information on securities or issuers is mixing science and art. Though it is increasingly science, there is little consistency across geographies or standard regulatory requirements for third party audit. Yet this information is the ‘raw data’ used to construct ESG indices. ESG index construction is not the only issue. When the ESG index has been constructed, financial product providers and investors need to ensure that they are clear about any unintended consequences of selecting a specific ESG index. What are the implications for geographic or style bias? Have expected returns or volatility been stress-tested in various market environments?
The second group of challenges relates to both categories of passive investors. This category provides a more fundamental challenge. How can investors ensure they remain active owners while following a passive strategy? Passive investors are forced holders of index constituents, so divestment is largely not an option if ESG standards fall below a minimum level or engagement fails. One of the key attractions of passive portfolios is their diverse nature. However, this means individual single holdings represent only a small proportion of a total portfolio, passive investment groups have little financial incentive to be active owners when they can freeride on others’ efforts. Another disincentive to be an active owner and passive manager relates to stock lending. Stock lending is often an important element of a fund manager’s income – especially when the fees are, as is the case with passive funds, low. Stock lending provides an important source of revenue that is reduced if and when fund managers have to recall stock to vote at AGMs.
Yet the rise of passive investing and use of ESG indices is likely to increase over the coming years. The attractions of passive products and strategies is strong. To meet some of these challenges, the PRI is undertaking a consultation to try to identify some of the issues associated with the development of this market and gather feedback from our signatories and other stakeholders on how to minimise the negative and accentuate the positive of this growing market. The process will involve collecting a range of views from asset owners, asset managers and other service providers on 12 questions covering:
- identifying the challenges;
- creating solutions; and
- active ownership.
The responses to these questions will help the PRI develop further guidance on the incorporation of ESG factors into passive rule-based investment. If the passive investment market is to continue to flourish, then answers to some of the challenges need to be found and integrated into practice. We look forward to your input.
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