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Commentary

Indexed to Action

Sarita Gosrani, Director of ESG and Responsible Investment at bfinance, outlines five continuing challenges in the diverse and fast-evolving passive ESG investing sector.

The landscape of equity indices with ‘ESG’, ‘climate’ or similar labelling has improved substantially in recent years. Yet institutional investors seeking to replace passive equity exposures with a credible sustainability-oriented quasi-passive alternative must still tackle difficult questions, ranging from inadequate consideration of climate risk management to overall expense and cost transparency.

There is now a plethora of indices ranging from the very broad to the more narrowly thematic, including those with a specific environmental or social focus (eg climate, women’s leadership, minorities, etc). Even among indices with a similar stated mission, one finds a range of methodologies and differing levels of tracking error versus the market, not to mention various approaches to pricing.

The universe, moreover, is increasing all the time. Investor dissatisfaction with off-the-shelf offerings continues to be an important force for innovation, with allocators now frequently driving the development of new indices themselves, despite the additional time and expense involved.

Below, we review five challenges that have historically been significant within ‘passive ESG’ in equities and consider the extent of recent positive developments. First, however, it is important to understand the different approaches that investors might use when building a passive ESG-oriented portfolio.

Three paths to ‘passive’ ESG

While passive equity management is often perceived as a rather straightforward subject, the integration of ESG considerations is a complex affair, particularly for an investor who strives to maintain low tracking error and affordability – the two hallmark attractions of passive investing. There are, in essence, three potential implementation approaches.

The first approach entails tracking an existing ESG index, such as MSCI ‘ESG Leaders’ or Solactive ‘Paris-Aligned’. This has the advantage of simplicity, since a range of existing funds already track these indices, though there are more and more from which to choose. All indices begin with a parent index that provides the initial investment universe, followed by the application of an ESG methodology (exclusions, integration, thematic filters) to narrow the universe to a smaller set of companies that are then weighted and rebalanced based on the index’s rules. An investor wanting a small amount of additional customisation could implement a further screen or adjustment using a separately managed account (SMA).

The second route takes customisation to the next level: an investor can work directly with an index provider to create a bespoke ESG index. There has been a surge in this type of activity in recent years with investors focusing on specific themes or trying to overcome what they perceive as failings in existing indices (such as a focus on carbon emissions data over climate risk). These involve even higher licensing fees and a greater initial outlay of effort on behalf of the investor, but the tracking process thereafter aligns with conventional methods.

Third, and perhaps less well publicised, is an asset manager-driven approach: optimised replication of a broad market index. A passive-like or rules-based ESG strategy doesn’t require reference to an ESG index. An asset manager can use a mainstream market index and then apply optimisation techniques to build a portfolio that meets an investor’s ESG requirements. This can be particularly suitable for investors with extensive stock exclusion lists or specific climate or carbon-related requirements. While asset manager fees for this method will be more expensive, the index licensing costs are cheaper.

Challenge 1: Backward-looking data

The first, and perhaps most intractable, issue that passive ESG investors must contend with is the inherently backward-looking nature of much ESG data. Today, however, we find a growing number of strategies that try to bring in a forward-looking element, such as adjusting weightings for positive ‘momentum’ in ESG ratings. These tend to be ‘darker green’ in their labelling, with complex proprietary methodologies.

Progress notwithstanding, the use of forward-looking data can seem problematic. These products can risk being viewed as too complicated: a ‘black box’ approach can put off investors who wish to see transparency in the index construction methodology. Moreover, the forward-looking data is typically used to supplement backward-looking data (the original challenge is mitigated but not eradicated). Missing data points and estimation are commonplace. It could be argued that any approach relying heavily on data, even if it is more forward-looking in nature, will inevitably exhibit some shortcomings versus a qualitative real-world assessment. Finally, forward-looking data is most advanced on the climate side (climate alignment targets, science-based targets) but we still see very little evidence of forward-looking data points addressing ‘social’ topics.

Challenge 2: Tolerance for active risk

‘Passive’ ESG equity strategies typically use two benchmarks: the chosen ESG index is usually the primary benchmark, and a mainstream non-ESG index is used as a secondary benchmark in order for the investor to understand the active risk of the portfolio.

The amount of active risk being taken is a live and difficult subject, particularly after a couple of years when many ESG indices have underperformed mainstream market benchmarks. Before the Covid-19 pandemic, study after study reinforced the message that ESG should not detract from performance and evidence of non-concessionary returns helped to propel ‘passive’ ESG equity to the investment mainstream. Underperformance in the 2021-2023 period can be attributed to specific tilts and exclusions. For example, 2022 punished energy underexposure, while 2023 saw ESG strategies over-exposed to cleantech and underweight in the runaway big tech stocks.

While short-term underperformance of active ESG strategies can be debated away through a variety of acceptable stylistic and strategic arguments, ‘passive ESG’ is perhaps more vulnerable to such critique. Those constructing indices often explicitly seek to minimise undesired sector/style tilts, precisely in order to reduce the probability of damaging deviations. Many indices apply an optimisation as part of the construction methodology with a parameter intended to minimise active risk.

There is huge variation among today’s family of ESG indices in terms of how much active risk (tracking error) they exhibit versus the underlying market benchmark. Indices with minimal ESG exclusions can have very low active risk (1% or less); those seeking a best-in-class ESG approach will naturally have higher active risk (1-3%); those with very differentiated approaches (eg Paris-aligned benchmarks and other customised climate indices) can have 4%+ tracking error.

In practice, we find that investors today are increasingly willing to tolerate a considerable amount of active risk, and that this tolerance tends to increase for investors who have more specific and proprietary ESG approaches. Investors using ‘passive ESG’ for the first time will be more likely to prefer a small degree of differentiation from the benchmark.

Challenge 3: Real-world relevance

All climate-oriented equity strategies, to some extent, face difficult questions regarding ‘real-world’ decarbonisation (the need to encourage transition, including for high-polluting industries that are necessary to economic change) as well as climate risk management (a low emissions/carbon intensity number doesn’t mean a stock is not exposed to climate risk). These are both challenges that we have observed investors tackling vigorously when developing bespoke indices directly with index providers. Although significant advances are being made on both fronts, the bulk of indices are still deriving the bulk of their ‘decarbonisation’ from simply underweighting industries and stocks with high emissions – an approach that is inherently not transition-friendly. Investors may wish to consider, as part of this question, whether managers are using the levers of stewardship that are available to them to drive change.

Challenge 4: Engagement and divestment

Speaking of stewardship, passive ESG equity managers have been criticised over the years for their lack of meaningful engagement with portfolio companies. While there is plenty of evidence that engagement programmes have become more substantial and well-resourced, investors may wish to consider whether the ultimate step—divestment—is actually being applied where activity has not delivered the desired results. We now see certain examples where managers of passive ESG equity strategies are demonstrating a willingness to ‘close the book’.

Challenge 5: Cost complexity

There are two main components to cost, not including the expenses that an investor may incur in-house: investment management fee and the index licensing fee. Moreover, investors that need data for reporting (eg climate reporting for regulatory purposes) must also factor in additional charges; these costs can be large and investors may incorrectly assume that they’re covered by the index licensing arrangement.

Licensing fees for ESG indices are typically higher than standard market indices (by around 0.5-1 basis point, depending on the level of ESG integration and complexity involved). For custom indices, investors can expect a further premium. Moreover, investors can encounter a lack of transparency. A passive fund manager will not only pay for the index provider rights to use the index; they will also usually pay an additional fee per annum based on the AUM linked to that index (often expressed in basis points). The pass-through of these costs is not always evident to the client. Certain index providers may not even permit asset managers to disclose the licensing fees.

Meanwhile, investment management fees vary considerably depending on factors such as mandate size, the decision to use an SMA versus a pooled fund and the extent of any additional customisation requests.

Evolution and improvement

While there have certainly been considerable improvements in the realm of passive ESG, investors should continue to avoid complacency. It is important that the chosen solution reflects specific financial and non-financial objectives, tolerance for tracking error, cost sensitivities, flexibility to evolve (as further advances take place) and more.

This article was co-authored by Kathryn Saklatvala, Head of Investment Content at bfinance.

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