ESG in passive: let the buyer beware
ESG in passive: let the buyer beware
Are investors ignoring the small print in their rush to buy funds incorporating environmental, social and governance (ESG) principles?
There has certainly been no shortage of demand. From what was virtually a standing start 12 years ago, $2.9 billion flowed into these “sustainability” funds in 2017.
It will surprise no-one that at least half of those flows were into exchange traded funds (ETFs). Passive ETFs neatly tick two of the boxes high on investors’ current list of priorities: low fees and meeting ESG concerns.
We worry, however, that many passive ETFs and open-ended funds are pitched to exploit investors’ preference for simple, low-cost solutions, rather than providing either the financial or the sustainability outcomes that those same investors expect.
Unlike the more objective measures that typically form the basis of passive ETF construction, such as market capitalisation, sector or domicile, ESG indicators are the result of a series of judgements and analyses that can vary significantly and lead to very different conclusions.
Undertaking such analysis is expensive, and often more than low-cost passive products can afford. A cheaper way for passive ETFs is to use the ESG ratings provided by one of a handful of data providers, such as MSCI, Sustainalytics and Thomson Reuters.
In arriving at an ESG score, each data provider synthesises their sustainability analysis into a single measure, akin to the stock recommendations investment banks or credit rating agencies produce.
Having several of these diverse views may be valuable for fund managers seeking to better understand a business.
However, it would make little sense for them to use a single analyst’s research to form a definitive view of a stock’s attractiveness. All the more so if they had no clear understanding of the analyst’s research process, the basis for their conclusions or the outcomes the recommendations were designed to achieve.
We would argue that this is essentially what investors are signing up for when they buy a passive ESG fund.
Despite the perception of transparency, many passive products disclose surprisingly little about how they actually implement ESG factors.
The majority of them rely on a single third party ESG rating provider. Their rating methodologies typically emphasise tick-the-box policies and disclosure levels, data points unrelated to investment performance and/or backward-looking negative events with little predictive power.
Most of the inputs to these scores relate to policies rather than more tangible measures of performance.
These shortcomings are reflected in the lack of consistency in ESG scores between the main data providers. Using all the MSCI ACWI constituents, we analysed the overlap of ESG scores for each of the three main data providers at the company level, as well as between the three ESG categories, environmental, social and governance.
As can be seen from our first chart, the level of overlap between the scores given by the ratings providers is surprisingly low. It was a similar story when we calculated the correlations across the entire company dataset of E, S and G (second chart).
This lack of consistency is concerning. As the majority of passive processes eliminate companies with weak ESG scores, portfolios created using different scoring systems are likely to have radically different constituents.
By the same token, the widely varying assessments of how strong a company is on environmental, social or governance grounds means investors seeking to allocate to best-in-class companies on ESG grounds will come up with very different answers, depending on which rating provider they use.
Similar problems arise when it comes to stewardship. Many investors buy ESG funds on the basis that their managers will be better stewards of the companies they invest in.
Unfortunately, it is very hard to engage effectively with companies and bring about change using mechanical processes that lack the specialist knowledge of both the industry and how individual businesses are likely to be affected by ESG issues.
We would argue that this is less of an issue for an active management firm, where stewardship is an important element of its role and a responsibility of fund managers, analysts and sustainability experts alike.
We believe that oversight is made easier by an active investment philosophy, where regular management meetings can be complemented by targeted engagements on specific company, environmental and social issues.
We think it is clear that investors’ expectations of sustainability cannot be truly met by passive funds. In our view, the most effective way to do this is to integrate ESG expertise into active investment solutions.
These should be designed to address investment-relevant ESG issues, both at the company-specific level and at the portfolio construction level.
The manager of the portfolio should then be able use their expertise to undertake targeted engagements with companies throughout the life of the investment with the aim of improving both returns and capital stewardship for investors.
Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.