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Active versus Passive: The ESG debate

Date: 12 October 2021

Today I’m going to combine a couple of perennially popular topics, namely the active vs passive debate and responsible investing. What do I specifically mean by responsible investing? I think it is best described by the UNPRI, who define this as “A strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership”. With COP26 in Glasgow getting ever closer, discussions on everything ESG related is getting ever louder, so we are going to add to the debate.

I should start by making a couple of statements about our views on the two subjects more broadly. Like many, I think we have largely moved past the either or debate when it comes to active versus passive. There is much to be said for both, but most investors are likely to own both, although for us, this is heavily biased in favour of active managers in most cases. In terms of responsible investing, this is clearly no longer something a niche area, and every manager meeting we have involves discussion of the issues relevant to that particular manager. We are very much focused on engaging with managers we own that haven’t progressed sufficiently in our view.

When it comes to active versus passive within the responsible investing space, there is much criticism of the passive providers, and today I want to explore how much is justified and how much is simply the active manager marketing machine speaking. We can really split this into two sections. The first relates to broad market passives with no specific ESG overlay, and how they are dealing with the challenges thrown up by the topic versus active managers. The second part relates to active and passive funds more focused on responsible investing, and how they compare.

Starting with broad market index passives, there are several potential limitations. The most obvious one is the inability to divest from a stock if it is in the index. Being forced owners of some of the weakest companies from an ESG perspective can elicit a lot of criticism. Passive providers have countered this by arguing that they are the ultimate long- term investors. If the company is in the index, they will own it in perpetuity or until it falls out. That in turn might mean that they spend a lot more time engaging with those companies, which is another important topic.

On that point however, critics will point to the vast number of companies invested, and the still relatively small teams in comparison, albeit they are certainly growing. Across the passive providers we meet with regularly we see a range of outcomes. I won’t embarrass the weakest, but I would like to highlight one we think is doing a particularly good job, which is L&G. They have actively excluded stocks that fail certain criteria, notably persistent UN Global Compact offenders and have proved to be good active engagers in our view.

Flipping this on its head, active managers will often claim both to provide more active engagement, given their greater focus on a smaller number of companies, and greater in-depth knowledge of the specific issues for those companies. I think that is a reasonable claim in many cases, although personally I think that is best expressed within some of the more focused boutiques who are both well-resourced and in aggregate own far fewer holdings across their firms. If one were going to be critical, we point out that some of the largest active managers do themselves have a considerable list of holdings firmwide and might suffer from some of the lack of focus that is levelled at the passive providers. Equally, teams that are not well resourced might find this additional area of focus quite a burden to put in practice.

Of course, what all active managers have within their power is the ability to divest, although clearly doing so is a last resort.

One of the advantages that I think active investors do have is potentially spotting those improving stocks with ESG momentum behind them, for which there has been reasonable evidence that this can be an alpha source.

Let’s turn to the growing trend towards investing in active products focused on responsible investing versus tilted index products, which is where I’m sure we will see continued growth in the coming years. The growth in broad market passives was built on two interconnected issues, namely the inability of active managers to outperform the market consistently, and cost considerations. and it is worth exploring these in the context of funds focused on responsible investing. In terms of performance, many active managers in this space have done well in recent years. We need to caveat that by also reminding ourselves that there has been a strong style tailwind in recent years, 2021 excepted. Nonetheless, most managers in the space will most likely stack up well versus a broad market index, and I’d argue that recent experience does not provide a good argument for going passive.

On the point of relative cost, the use of passive has been driven just as much by advisers wishing to provide the cheapest products to their clients. How do products in the responsible investment space stack up? In my experience we have seen some of the tilted passive products priced somewhat higher than standard passives, but still a long way below active managers in most cases. On the active side, there is somewhat of a split. Products that have gained traction and assets tend to be priced higher, but equally there are a huge number of new launches in the space, and every asset manager is looking to get them off the ground and to a size that doesn’t preclude certain investors who need higher starting fund assets before they can invest. In that situation there are potentially attractive seed terms for those willing to invest early, and that may get you nearer to passive levels. That of course comes with potential risk and isn’t something the average retail client would be able to take advantage off unless it is through a firm like ours.

Tilted passive funds are intended to remove the obstacle of their inability to divest. These passives are intended in the most part to avoid specific parts of the market through whichever ESG lens they are focusing. However, another concern put forward is an over reliance on the data providers in determining what they screen out. As it stands, the criticism of the ratings providers has some measure of truth in it, not least the lack of correlation between providers ratings and perhaps some of the obvious qualitative misses given it is by nature so data-driven. One of the more extreme examples of this is in Japan, where many smaller companies are penalised for failing to update major databases in English, which can have a negative effect on their rating, even if they would otherwise warrant a very good rating. In my research in that area, there seems to be a mini-industry growing up trying to change this, and of course be invested at the point that the company moves up the ESG rating scale.

On a more positive note for tilted passives, we continue to see product innovation, for example those that are specifically aligned to climate transition indices aimed at aligning to Paris agreements limiting global warming. We should equally be cognisant of the risk of greenwashing from active funds. As a team we spend a lot of time on this subject in manager meetings, but for the average retail investor, it is much harder to determine either way.

One of the advantages that I think active investors do have is potentially spotting those improving stocks with ESG momentum behind them, for which there has been reasonable evidence that this can be an alpha source. Companies that score poorly today and are either absent from a tilted index or simply market weight in a generalist passive product can be spotted first by active managers, or indeed may be improving because of the engagement that active manager has. The reverse might equally be true, with companies going in reverse taking time to be picked up by the ESG ratings providers.

So, what do we conclude from all this?  Clearly active managers have seized the opportunity that the focus on responsible investing and ESG has afforded them, namely an area in which they can grow rather than see their lunch steadily eaten by the passive industry. I think there are strong arguments for those managers who lead the market in terms of their ESG practices and own a more focused number of holdings where they potentially might have a greater impact via engagement. That said, where passive providers do focus their energies, the sheer quantum of investment clearly has the potential to be impactful.

For funds focused on responsible investing, the arguments that held for investing in passive historically seem to hold less well today, with active performance generally pretty good, helped by style tailwinds, but nonetheless performing well. That said, we do think tilted passive investments potentially have a relevance in a portfolio. That might be because it achieves specific needs that we can’t achieve with active managers, whilst we are happy to balance best in breed passive alongside active, especially where that makes the overall cost to the client more reasonable. However, the balance is very firmly in favour of active management in our view, and the challenge remains to find those best in class managers as the number of fund launches grows ever longer.

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