Passive ESG strategies increasingly sophisticated

Institutional investors are realizing they can do what's good for their assets, their budgets and their consciences all at the same time, as the integration of environmental, social and governance factors into their passive allocations becomes increasingly sophisticated.

However, some dispute that investing in strategies that tweak and track an index can bring institutional investors up to scratch when it comes to being truly responsible asset owners.

The implementation of ESG factors into active portfolios has long been an option available to investors — from divesting certain stocks and in some cases whole industries, to engaging with companies to help them improve their sustainability. Similarly, the option for passive investors to simply cut areas of indexes that they find unpalatable from a responsible investment point of view, has also long been available. But institutional investors now are approaching money managers and index providers to help them become more responsible investors in their passive allocations in ways that previously would have been the mainstay of a sophisticated, and pricey, active approach to investment.

There have been a number of recent examples of institutional investors and index providers tweaking index strategies to satisfy a particular element of responsible investment that they wish to exploit or exclude. Some are tilted toward companies that promote gender diversity and equality; others focus on the long-term sustainability.

“We have been approached by a growing number of clients who wish to combine traditional investment factors, such as quality or minimum volatility, with ESG signals,” said Thomas Kuh, global head of ESG indexes at MSCI Inc. in Boston. “This reflects the intersection of three current trends: ESG, factor and passive investing.”

Philippe Desfosses, CEO of the €23 billion ($25.5 billion) Etablissement de Retraite Additionnelle de la Fonction Publique, Paris, said it is important to work with index providers to develop benchmarks.

“Index providers have finally got that they have to offer an alternative to pure market cap,” Mr. Desfosses said. “It is interesting to see how index providers … have been working to take into account these new demands, and they have really started to create different indexes. It is very important because trustees need something to benchmark their performance to. And we have more low-carbon indexes, and we have also ESG indexes. Maybe more than half the assets owned by institutional investors are passively managed, so it is very important to get on board.”

Sustainable investment firm RobecoSAM has seen the biggest inflows to ESG indexes in its history in the first half of 2016, said Guido Giese, head of indexes in Zurich. “People are now aware that a lot of things they may have done in the past in an active portfolio, they can now do in passive. A lot of pension funds are coming to us and saying we want a passive solution, that is more cost effective and transparent, but want the same complexity as an active portfolio for ESG.”

Mr. Giese thinks one reason for the pickup is the incorporation of ESG alongside financial factors.

One example of that, which the firm helped develop, is the S&P Long-Term Value Creation Global index, which combines qualitative and quantitative measures into a single metric to determine the potential for a company's long-term value creation. It launched in January and has attracted $2 billion of commitments from institutional investors, including the C$278.9 billion ($214.4 billion) Canada Pension Plan Investment Board, Toronto. The fund allocated C$1 billion to an internally managed portfolio tracking the index.

“(Investors) came to us with a clear view that they only wanted a governance score combined with traditional financial factors. We believe it makes sense to look at both sides of the coin — the financial side and the governance side. Five years ago we might have said this was an active strategy — but we basically launched it as an index, it is purely rules-based, and is very much driven by the requirements of the client. It is not about making the world a better place, but picking companies that (investors) can invest in over the long run,” said Mr. Giese.

RobecoSAM has also worked with S&P Dow Jones Indices to establish ESG as a stand-alone factor for investment. “We spent three years crunching the data with our quant team … collecting over 600 ESG indicators such as gender diversity and energy efficiency.” The firm takes those data points and analyzes them for indicators of alpha within each individual industry of stocks.

The €37.2 billion Fonds de Reserves pour les Retraites, Paris, has applied a methodology that takes climate change into account within its passive allocation. It was an early adopter of MSCI's low-carbon indexes, said Salwa Boussoukaya-Nasr, chief investment officer at the fund, and was keen to keep the tracking error vs. the cap-weighted index very low. “It was not just basic optimization but the idea of best in class, which leaves the possibility for a company to improve itself and to gain, in the end, access to the index,” she said.

Ms. Boussoukaya-Nasr said the fund moved about 20% of its equity allocation to this index and also required from its smart beta managers a further 20% of the equity allocation, with the aim of adding a decarbonization process to investments while ensuring the smart beta characteristics were still valid, she said. In its requests for proposals, FRR intends to go beyond this process, asking money managers to add another layer of ESG criteria.

“For us it is passive in the sense that it has very low tracking error to the benchmark. We don't want an active process with the manager selecting companies, and turnover (of stocks). But when you choose what companies are in the investment universe and what companies have to be excluded or underweighted, sometimes someone has to have a little qualitative judgment on that, before you use optimization to find the best portfolio. There needs to be a human somewhere to have an insight on the company's quality,” she said.

But there is a challenge when it comes to the integration of responsible investment approaches into passive allocations. “The challenge when you are a passive owner is that you are a universal owner,” said David Sheasby, head of governance and sustainability at Martin Currie Investment Management Ltd. in Edinburgh. “So the only way you can really incorporate ESG into a passive strategy is to engage with the company you are investing in — people don't have the ultimate sanction of walking away.”

Engaging with hundreds or potentially thousands of stocks in an index is a challenge, he said. “As an index manager or owner you have a huge number of companies to monitor. If you say the path to ESG in a passive strategy is engagement, you have to decide how,” considering whether there is sufficient data, how to identify engagement issues, how to prioritize those engagements, and who will take that role on within the firm.

Still, “there are some very valid attempts to tweak the indices for certain issues,” such as climate change, he said.

“We are slightly biased as managers of an active ESG fund, but it is something I firmly believe that, if you are purely an old-fashioned passive investor, then no, you cannot truly be ESG aware,” said Lewis Grant, portfolio manager at Hermes Investment Management in London. “I think the passive world is starting to realize that they will need to pay a little more to be truly ESG aware, but it still means they are limited in that they don't have the ability to allocate capital to companies less exposed to ESG issues, and don't have the ultimate tools to divest.”

It is also difficult to find an index that truly reflects everyone's values. “There are a lot of indexes with different divestments, but everyone has their own view of ethics and sustainability,” said Mr. Grant. “If you are a passive investor you can follow someone else's definition of what ESG means. Some use a modified ESG benchmark — that is a step in the right direction, but again there are flaws with that approach” since indexes may be slow and backward-looking in the data.