Passive Environmental, Social, and Governance Investing is Set to Grow

The integration of environmental, social, and governance (ESG) considerations into passive investing is gathering momentum, but there are potential pitfalls ahead, according to the latest The Cerulli Edge—Europe Edition.

The proliferation of new indices constructed to tilt and weight benchmark components in accordance with investors’ climate, social, or governance priorities is increasingly fueling industry debate on how to meaningfully integrate ESG considerations into passive strategies, says Cerulli Associates, a global research and consulting firm.

Fabrizio Zumbo, associate director of European asset management research at Cerulli, says that rapid innovation in smart beta and factor investing is one of the main catalysts of increased product availability for European investors. Although demand for responsible investment indices is expected to keep growing, the risk is that they could fail to match the sustainability criteria investors believe they are buying.

For example, environmental-themed indices typically tilted away from big polluters initially. The next phase was to tilt away from companies with large fossil fuel reserves. Now the emphasis is on increasing exposure to companies with revenues exposed to the “green economy.” However, climate risk and its potential impact on portfolios in the future is a complex matter. The issue is further complicated by the fact that managers are packing different visions of—and beliefs about—ESG into their low-cost products.

The successful integration of ESG into passive strategies will, however, ultimately depend on managers being able to enhance their stewardship of and their engagement with the thousands of companies they track, says Cerulli. The difficulties include managers’ limited capacity to dynamically monitor the huge number of companies contained in the indices they track, a shortage of meaningful forward-looking data, and the absence of universally agreed ESG definitions, concepts, and beliefs.

The credibility of passive ESG strategies will be at risk if, for example, passive exchange-traded funds (ETFs) do not match the sustainability criteria investors think they are buying. ETFs tend to use benchmarks offered by the major index providers, but they may have little predictive power. In addition, portfolios created using different scoring systems are likely to have radically different constituents, resulting in different outcomes depending on which methodology they use.

Nevertheless, according to Zumbo, “Passive managers as well as large active managers that have entered the passive space have a real opportunity to offer robust stewardship and deep engagement with their investments. They can leverage their long horizons and sizeable stakes to provide effective ESG options in the passive space.”

OTHER FINDINGS:

• London-listed closed-end funds raised £6.6 billion (US$8.3 billion) in the first nine months of this year, up 20% from the same period in 2018, notes Cerulli. The bulk of this capital went into specialist property, debt, and renewable energy investment companies. Family offices and similarly sophisticated investors are behind much of the demand for closed-end funds.

• Europe’s pension schemes are looking to extend their fixed-income investments to the entire spread of the credit market. Some 14% of the respondents to a Cerulli survey intend to increase their allocation to high-yield bonds and 15% plan to increase their investments in emerging market debt.

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