Why Sustainable Investors May Rue Being Too Passive

Passive sustainable funds are growing strongly. But sustainable investors are at risk of a mismatch between what they expect and the reality of what they receive.

Growing social and environmental pressures are reshaping economies and industries before our very eyes.

This creates both risks and opportunities for investors whose portfolios need to reflect the changing world we live in.

Against this challenging backdrop, a forward-looking view of our fast-evolving world, rather than relying on past success drivers, will prove critical.

Yet the growth of passive funds over recent years is unlikely to align with this focus.

Passives now account for over one-quarter of global investments in sustainable funds. And while their momentum has clearly demonstrated the demand for low-cost, easy access to global markets, sustainable investors in passive funds risk a mismatch between what they expect and the reality of what they receive.

For when it comes to traditional investment criteria, views of “large cap” or “high yield” are relatively consistent, meaning sustainable investors in passive strategies focusing on those characteristics have a good idea of the sorts of stocks those funds will hold.

But, sustainable investment is very different. There are stark inconsistencies between the company scores determined by different ESG rating firms, many of which are used to populate the indices of numerous passive ESG products.

This is clear even amongst the most widely used and well-known scoring systems for company ESG measurement. Passive ESG strategies are, therefore, only as valuable as the ratings on which they are based, which, as our research demonstrates, vary considerably. Furthermore, many ratings are backwards-looking and usually fail to predict controversies.

This is not surprising. For one thing, ESG analysis encompasses a huge range of topics, and the importance attached to each can vary significantly. More importantly, quantitative analysis alone cannot capture sustainability performance alone, underpinning the importance of an active investment approach.

Identifying a company’s ESG characteristics requires fundamental, bottom-up, forward-looking analysis, where views are unavoidably going to differ across firms.

For active managers, this creates opportunity. Active managers, by their very nature, will have a vested interest in the companies in which they invest: sustainable businesses underpin sustainable returns, so helping businesses become more sustainable is likely to benefit their overall portfolio and the returns for clients.

Their extensive insight and knowledge into companies and industries are critical to meaningful and thoughtful discussions to help drive change, tackle challenges and ensure company management teams are held to account to make the transition.

There is no simple, single answer to achieving a sustainable future. It will require significant time and investment in helping local and global corporates make the change.

So, how can we accelerate this?

Rather than using screens to exclude vast swathes of the benchmark, which we have shown to be based on significantly differing data, the key approach is to engage and influence as thoughtfully and comprehensively as possible. This ethos has been long established at Schroders and is an inseparable part of our investment process.

Most of our fund managers and analysts now have targets for high-quality engagements. From this year, these are assessed and form part of fund manager appraisals, and the results, therefore, affect their compensation. Over time, we expect the breadth and intensity of our engagements to continue to grow.

But engagement by itself is not enough. Measurement is critical to success. Any fund manager making a decision without first assessing the costs or benefits each company has for the environment and society is, to put it bluntly, flying blind.

The results of our latest Institutional Investor Study clearly show that clients are also keen to understand. We must strive to show how different company behaviours on issues such as taxation, healthcare and innovation can deliver social costs or benefits.

We must also offer a granular view of carbon emissions on a company-by-company basis; not just focus on the emissions accrued directly or through the firm’s value chain, but also consider the knock-on emissions created and rarely accounted for.

There are other factors and nuances to consider in this debate. While it is true that large, passive managers have increased the sizes of their stewardship teams, a scaling up of thoughtful, critical analysis and diligence is far more difficult to replicate.

Clients will make their own assessments. By asking each portfolio manager for clear examples of effective engagement and a clear view of their portfolios’ sustainability profile, they can make a clear-sighted judgement.

Over the long term, the importance of an active approach to sustainable investment will only become increasingly obvious.

Written by: Rory Bateman, Co-Head of Investment and Head of Equities, Schroders

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