Is passive investing killing ESG?

When it comes to investing there are currently two big trends: ESG and low cost. Passive ESG investing is relatively cheap and efficient. What could possibly be wrong with a fund that ticks both the low cost and the ESG boxes?

Someone trying to remove an 'Ethics' block from a Jenga tower
"The concept of ethical investing is highly subjective but it all hinges on what's more important to an investor: cost or commitment to beliefs?"

ESG criteria are a set of standards for a company's operations that socially conscious investors use to screen potential investments; environmental criteria consider how a company performs as a steward of nature; social criteria look at how it manages relationships with employees, suppliers, customers, and the communities where it operates; governance deals with a company's leadership, executive pay, audits, internal controls, and shareholder rights.

ESG indicators are the result of a series of judgements and analyses that vary a great deal and lead to diverse conclusions. Passive funds track an index from data providers such as the MSCI, Sustainalytics and Thomson Reuters. Their rating methodologies are generally based on tick-the-box policies and some passive products don't fully disclose how they implement ESG factors. To produce an ESG score, each data provider blends their sustainability analysis into a single measure. Using mechanical processes such as these doesn't allow effective engagement with companies to encourage change. In addition, the lack of specialist knowledge of both the industry and how individual businesses are likely to be affected by ESG issues begs the question of passive funds being pitched to exploit a preference for simple, low-cost solutions, rather than focussing on expected financial or sustainability outcomes. Are investors ignoring the small print in their rush to buy funds incorporating ESG principles?

Some indices have negative screens that perform a filtering process. The companies that are left after the sifting has taken place are considered to be ethical, but is this really the case? One of the largest weightings in ESG passive funds is Tesla. On the one hand, Tesla is leading the way in reducing carbon with electric cars but on the other, the batteries used in their cars contain minerals sourced from some cobalt mines where child labour is used. Does Tesla meet ESG criteria? Some may argue the EV revolution needs to be green from end to end for Tesla to be considered ethical. Following an index does cut costs but without active investment management, there's no option to look at a company in detail with an ESG lens and, in practice, there's little stopping a seemingly unethical stock from having a high ESG score. Oil companies, tobacco companies, gamblers, polluters, plastic manufacturers can all score well if they have the right statements and policies in place.

Another example is Facebook. Large media firms hold a lot of information about everyone. You may not even use their product but your appearance in someone's contact list will reveal a lot about you. This information is used to sell targeted advertising. Facebook analyses communication patterns and determines our moods, the strength of our relationships and our tolerance levels. Facebook's ethical lapses have generally involved the mishandling of data. Does this meet your ethical test? An active manager looks at all the different elements of a company's structure and behaviour to make a call on whether they meet their criteria but with the passive approach, the fine line can't be managed or controlled.

If someone really cares about climate change and the role of fossil fuels, how can their portfolio include investments into oil companies? When it comes to ESG, the value of an active manager is becoming more obvious. By qualitatively looking at the stocks they own, an active manager can be a lot more targeted and reflective about what an investor might expect from something that has a green badge. Active investment philosophy means regular management meetings complemented by targeted engagements on specific company, environmental and social issues producing a true and detailed picture of a company, its corporate culture, and its future commitments. Active investment solutions are designed to address investment-relevant ESG issues, both at the company-specific level and at the portfolio construction level with the manager of the portfolio using their expertise to undertake targeted engagements with companies throughout the life of the investment, aiming to improve both returns and capital stewardship.

One person's idea of ethical may not be shared by another. If an investor has specific expectations of sustainability, can they be met by passive funds? Some may say that passive ESG funds should only be bought for clients who are not fully committed to the principles of ESG. If you genuinely want to invest in ways that make a difference and impact positively, there's an absence of passive options that meet these expectations. Active management may cost more but it adds significant value; an investment approach that looks in detail at the underlying characteristics of the companies in which it invests will produce an exhaustive picture, ensuring a potential investment meets a predefined set of ESG standards.

We launched the SRI rating in 2012 – the first of its kind in the UK. Our Responsible rated funds apply more than just ESG into their process and are categorised as sustainable, impact, thematic and ethical.

The demand for responsible investing is growing day by day and with our impartial, qualitative research and forward-looking perspective, we'll stay at the forefront of this evolving and exciting area of the market.

To find out more about RSMR Responsible Portfolios head to: rsmr.co.uk/about-us/services/