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Passive ESG Strategies Have Momentum – Morningstar

Lower fees, advancements in indexing and “lacklustre performance” by rivals see inflows to passive ESG funds outweigh their active counterparts.

Investors that want to invest sustainably, increasingly want to do so passively, Hortense Bioy, Global Director of Sustainability Research at Morningstar, told a roundtable event hosted by the data and research firm this week. 

According to a recent Global Sustainable Fund Flows report, passive strategies represent almost a quarter of ESG fund assets globally, but they also account for most of the most popular ‘green’ investment vehicles. 

In the fourth quarter (Q4) of 2022, flows into the European sustainable fund universe rebounded after a three-consecutive-quarter decline and stood at almost US$40 billion, the report said. This represents a noticeable 88% growth from the readjusted US$21.3 billion of net inflows of the previous quarter – most notably passive strategies pocketed over 60% of the new capital. 

“When you look at the top 10 sustainable fund flows, it’s always been stuffed with passive ESG funds,” Bioy told onlookers on Thursday. 

In Q4 2022, passive strategies continued their dominance (six out of 10) among the bestselling sustainable products globally, with them combined netting over US$6.7 billion of net new money, the report noted.  

Amid inflationary pressures, rising interest rates and the ongoing war in Ukraine, Mercer Passive Global High Yield Bond Fund topped the sustainable funds leader board, capturing inflows of US$2.1 billion alone, followed closely by an active strategy – BlackRock ACS North America ESG Insights Equity. 

“The growth in passive ESG funds is a direct result of technological advancements, particularly around indexing, but also improved ESG data over the past five to 10 years – you can’t do indexing if you do not have data,” Bioy said.  

“Index providers are hungry for new data – this is how you innovate,” she said, adding that asset managers now have greater amounts of climate, biodiversity and nature-related data due to improvements in voluntary financial and non-financial disclosure frameworks and requirements. 

In October 2021, the UK government made it mandatory for large businesses to disclose their climate-related risks and opportunities in line with Task Force on Climate-related Financial Disclosures (TCFD) recommendations.  

However, active funds continue to dominate new launches in the US, the report noted. Despite persistent investor preference for passive funds, 11 of the 17 sustainable funds launched in the US during Q4 2022 were actively managed. On average over the past three years, active funds have accounted for two thirds of sustainable fund launches, with Q4 2022 once again matching that growing trend at 65%. 

Passive pros and cons 

The biggest advantage of a passive ESG strategy over its active counterpart is the low cost, said Bioy, with fees for passive strategies much lower than those of active funds.   

Bioy told onlookers that fund management fees vary based on the sophistication of the strategy but noted that fees for passive ESG strategies are clearly much lower than fees for active ESG strategies and they’ve come down quite significantly in recent years. You can now find ESG ETFs at par with plain-vanilla non-ESG ETFs.

According to Morningstar’s latest European Active/Passive Barometer report, the biggest driver of active funds’ failure is their “inability to survive”, which is often a result of “lacklustre performance”, with the 10-year survivorship rate for active funds averaging 50% from February 2014 to present. This can be explained by a mix of wrong stock-picking decisions and the compounding negative effects of higher fees relative to their low-cost passive competitors, the report noted. 

Transparency is another advantage of passive funds, Bioy said, especially in the ESG space. 

“ESG investors want to know what they own – that’s a massive advantage for passive strategies,” she said. “Passive funds make perfect sense for investors that want to screen out unethical stocks. You don’t need an active manager for that, and you can easily implement negative screening passively.” 

Bioy noted that there are a number of “limitations” with passive ESG approaches, arguing that some strategies are “overly simplistic when ESG is, by nature, complex”.  

“Reducing the sustainability profile of a company to only one score or one rating can be overly limiting,” she said. “Passive ESG strategies rely on third-party ESG ratings. You have to be confident about the methodology underpinning those ratings, and we know that ESG scores and ratings can differ widely across providers.” 

ESG data providers “do not always agree” on what is and is not material, she said. 

“[Data providers] use a lot of data that is estimated [and] also is backward-looking by nature, so residual exposure to ESG risks may remain.” 

Certain ESG strategies, especially socially responsible investment (SRI) ones can exhibit strong biases (geographic, sector and quality biases), which can persist over time, she said.  

Bioy noted that sector biases in ESG passive funds led – with many being ‘overweight’ in tech and ‘underweight’ in energy – led to underperformance last year in particular. 

“No silver bullet” 

An obvious advantage of active ESG funds is that the integration of ESG factors into the investment process by portfolio managers can potentially generate alpha, she said.  

“Active managers can use ESG factors as an additional set of considerations that could give them an edge, which in turn could lead to better risk-adjusted returns over the long term.” 

Bioy noted that active managers also have greater “flexibility” and, therefore, are better able to adapt to company changes, allowing them to mitigate any geographic, sector or quality biases.   

“Active strategy, in theory, will always be more effective in allocating capital to companies that provide positive environmental and social benefits,” she said.  

Turning her attention to the disadvantages of an active approach to ESG, Bioy reiterated the inherently higher fees applied to investors in actively managed funds.  

As she pointed out, actively managed funds involve buying a wide range of ESG data, including newly developed alternative sources, which is not always “perfect” and so analysing it can be “extremely resource intensive” – resulting in higher fees.  

According to Morningstar, equal-weighted average fees for active funds sits at 1.03% in 2021, compared to an average of 0.55% for passive. 

Picking the right securities based on financial and ESG criteria requires scarce skills, she said, adding that despite the growing body of research highlighting a positive link between material ESG factors and company financial performance, it does not correlate that a fund manager managing an active ESG fund is inherently going to outperform the market. “ESG is no silver bullet”, Bioy observed. 

“At the end of the day, it really depends on their skills and finding active managers that possess those skills are hard to find,” she said. “It’s difficult to find good portfolio managers in the ESG space because the best managers don’t like to be constrained.” 

Bioy also noted the inherent risks of investing in products with little or no track record launched by new and potentially inexperienced teams.  

“ESG funds with the longest history are often run by managers with an ethical mindset but may still be managing the fund in the same way as they’ve done in the past, prioritising ethical characteristics over returns – that may suit certain investors, but not others.” 

After outlining the pros and cons of active and passive ESG funds, Bioy concluded that, ultimately, investors we’re likely to continue to “blend” active and passive strategies. 

“Investors will allocate assets to active managers when they think that the manager can add value,” she said. “When you’re an active manager, you’re more able to actually engage with every company you have in your portfolio, which you can’t do in the passive space.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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