So, you have decided you want to incorporate some environmental, social and governance (ESG) principles into your investment portfolio. You have read our guide on the different ESG styles of investing, but now you are faced with a key question: do you choose an active or passive fund?
As ever, it all depends on your goals and how much you are willing to pay to achieve them. To help you decide, we take a look at the differences between active and passive ways of investing sustainably and cover some of the pros and cons of each.
As you may remember from our Insight post on digging deeper into ESG, this style of investing originated back in the 1960s, when religious groups such as the Methodists, Quakers and Muslims launched the first ethical funds. Back then, any kind of ESG investing was considered to be niche and it was only decades later that investing with sustainability in mind would become popular. That popularity has more recently given rise to passive ways of investing sustainably, giving active managers a run for their money.
The aim of ethical/responsible investing is very much to screen out stocks and other assets that have a negative impact on the environment and society such as fossil fuels and weaponry. Sustainable and impact investing is less about relying on backward looking data and negative screening and more about investing in companies that will have a positive impact on the environment and society. This is one of the key points at which active and passive part ways.
Passive ESG strategies are typically focused on ethical/responsible investing by screening out certain sectors from an index and then tracking the remaining assets. Some try to go further than that but the fundamental constraints of passive investing (tracking a pre-determined group of assets) means that there isn’t really a way for passive strategies to take a forward-looking view, and that problem remains in passive ESG funds.
Having said that, there has been some innovation in how ESG indices are constructed with passive managers starting to use tilting mechanisms, re-balancing indices based on ESG scores for each underlying company, and creating indices aligned with the Paris Agreement goals. However, being passive indices, these are still subject to the same limitations. For example, re-balancing can only happen a few times a year and is still based on historical data. This data is also inconsistent and lacks universal standards, meaning there is no sure way for an investor to know how sustainable the companies in a passive ESG fund really are. Nor can they engage with companies on any of these matters.
Active managers on the other hand are all about forward-looking investment decisions, that is at the core of what they do. Whether they do it well or badly depends on the manager, but there tends to be clearly defined processes and forms of engagement with the companies they invest in. This is one of the main arguments for why active managers may be the best option for someone who wants to be a bit more active (no pun intended) in their sustainable investing.
Most active managers today also dedicate significant resources to ESG analysis covering an ever-growing range of issues as well as continuous engagement with the companies they invest in to push them to do better. It is not just about the current stage and state of the company, but also the direction of travel. And while regulatory pressures are growing for companies to act in accordance with strict ESG guidelines, today the onus is still on asset owners (and their managers) to ensure that the companies they invest in adhere to, and continue to improve, high standards.
Furthermore, the world’s largest passive asset managers – BlackRock and Vanguard – have long been criticised for voting down climate resolutions and refusing to engage with oil & gas majors on climate issues. However, this has not stopped demand for passive ESG products from growing rapidly, with investors attracted by the typically lower fees. Over the past three years, the number of passive ESG products and the amount of money invested in them has more than doubled. Cost is also the main disadvantage of active ESG funds because they tend to be more expensive than passives. However, fees have been on a declining trend for active funds over the last decade, including ESG funds, according to analysis from Refinitiv Lipper.
Lastly, greenwashing - which is basically marketing spin to persuade investors that their funds are more responsible/sustainable than they really are - is another big issue in the industry and one that both active and passive funds are guilty of. There are new European regulations on the horizon which aim to address this issue but we are still a long way from consistent quality when it comes to ESG funds.
There is a lot to think about when picking the management style for your ESG fund(s). In order to find the right solution, it is important to clearly identify your goals and reasons for investing sustainably. If you just want a cheap(ish) and easy way to screen out the worst offenders, then passive is probably the way to go. If you want your savings to have a measurable positive impact in the world, then active is probably the best choice. The saying goes: “you get what you pay for”, and in this case that is fairly accurate.
Date of publication: 2nd December 2020
The information in this post is not financial advice, it is provided solely to help you make your own investment decisions. If you are unsure about whether an investment is appropriate for you, please seek professional financial advice. You can find more information here.
When you invest you should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return.