Monday Morning Memo: Are ESG ETFs Too Passive For Implementing A Sustainable Investment Strategy?

As ETFs become increasingly successful in gathering assets from ESG-oriented investors, it is no surprise that active managers have started to claim that serious ESG strategies need active management. Since we know that similar claims from active managers over plain vanilla ETFs have been proven wrong in the past, one has to check if the new claims are true.

One of the major claims of the critiques is the fact that ESG indices, which are the basis for ESG ETFs, review their constituents only a few times a year and can’t in most cases react directly to controversies or scandals. Meanwhile, active managers can reevaluate the respective company immediately after a controversy appeared and sell their positions if necessary. Generally speaking, this claim is true, but some index promoters have created rules which allow them to make off-cycle constituent reviews if necessary. This means the respective indices and ETFs can react if an index constituent does no longer fulfill the criteria for inclusion within the respective index. From my point of view, it will be only a question of time until all sustainability indices will implement index rules which will allow them to review their constituents on a higher frequency and employ policies that will allow them to react immediately if a constituent no longer meets the inclusion criteria of an index.

Another major claim of active managers is that sustainable indices normally only use quantitative screens to determine their constituents. This means they are supporting only those companies which are already acting sustainable and won’t drive the change toward more sustainable business practices at companies which don’t have an integrated sustainable strategy yet, or fail to report on their sustainable strategy, as corporate sustainability reports beside other data sources are the basis for the evaluation of companies. This claim is also somewhat right, as a company has to have a sustainable strategy and need to fulfill the respective reporting requirements to become a member of an ESG index. That said, even active managers need data to determine which companies they include within their portfolios. Therefore, I would assume that this claim is only partly true. Nevertheless, some active managers do have strong engagement strategies and try to influence the boards of companies within their portfolios to change their strategies or single business practices toward a higher sustainability measured by the standards of the respective asset manager.

The same is true with regard to voting policies. Active managers who (should) have a dedicated view and vote respectively on corporate actions and decisions which have to be approved during the annual shareholder meetings. Conversely, managers of passive portfolios normally don’t take a position on these decisions and may have had no voting policy in the past, but this puts them under scrutiny from many institutional investors since they needed to fulfill their stewardship duties as trustees for their asset owners. Respectively, these investors rather used segregated accounts and mandates to fulfill these duties. But an increasing number of institutional investors in passive funds and ETFs shows that this has changed, and we see that a large number of passive managers are executing their voting rights nowadays, either via (and in-line with) their parent companies and/or by proxy representation voting. Nevertheless, there are still issues with regard to the execution of voting rights from different asset owners within pooled investment vehicles such as mutual funds and ETFs. However, this would be a topic for another article.

In general, it can be said that the claims by active managers are at least for the first two points partly true. With regard to the execution of shareholder rights such as voting, it can be concluded that this issue isn’t served yet and is true for both active and passive products. That said, one needs to bear in mind that we are still in an early phase of the evolution of passive ESG investing strategies. Therefore, I am pretty sure that the promoters of ESG indices are already working on improvements of the rules for their existing ESG indices which will tackle some of the weaknesses which have been addressed by critiques and investors. In addition, we will witness that the index promoters will launch a new generation of indices which are not only aligned with regulations like the SFDR, or the Paris climate agreement, but may also include room for companies that just have started their journey toward higher sustainability standards for their manufacturing and/or products. I am also sure that we will see new concepts from the promoters of passive products to institutionalize the execution of shareholder rights. This means ETFs and other passive products are not too passive to implement a sustainable investment strategy by themselves and will become even more active within the foreseeable future.

Detlef Glow is Head of EMEA Research at Refinitiv Lipper. 

The views expressed are the views of the author, not necessarily those of Lipper or Refinitiv.

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