The growth of passive investing and the increased integration of environmental, social, and governance (ESG) factors into investment decisions are two of the largest investing trends in recent years.

The growth in passive funds has been mainly driven by a combination of factors, including new financial products such as exchange traded funds (ETFs), a focus on cost reduction, and ongoing debate on the relative benefits of active versus passive investing. Interest in responsible investing has come from a desire to reflect investor values in investment strategies, along with an increased availability of ESG data and evidence on a correlation between ESG incorporation and enhanced risk-adjusted returns. Both these trends have come together to accelerate the growth in assets managed using passive ESG strategies.

However, investors need to be aware of several challenges when incorporating ESG factors into passive investing strategies. These include technical issues surrounding ESG incorporation such as ESG data quality, consistency, and varying index and benchmark construction methodologies. Additionally, the degree of active ownership, an important component of shareholder responsibilities, can diminish for those following a passive strategy.

Availability and consistency of ESG data

The collection and publication of ESG data by companies is generally voluntary (with some national and regional exceptions), resulting in limited availability and little standardisation. Additionally, there is a risk that companies limit disclosure to only positive information. The lack of a defined global taxonomy and regulatory disclosure requirements for ESG data has resulted in a range of ESG data collection methodologies and comparable data that is less than robust. This is reflected in the widely varying correlations State Street found between the main ESG data providers on their ESG scores.

Cross-sectional correlation for constituents of the MSCI World Index, June 30, 2017 

Source: The ESG Data Challenge, State Street Global Advisers, March 2019

This lack of consistency creates challenges in the construction of ESG benchmarks and passive strategies, as these scores inform integration (weighting/tilting) decisions. Despite these challenges, ESG scores are used in the construction of benchmarks or indexes. As a result, investment managers and asset owners are keen to encourage greater consistency and comparability across scoring methodologies.[1]  

Complexity and transparency issues

As ESG passive strategies attract growing volumes of assets under management, the construction of the underlining benchmarks will come under increased scrutiny.[2] Compared with market capitalisation indexes, the construction of ESG indexes often requires complicated calculations and qualitative judgments.[3] While most index providers publish some details of their index construction methodologies to improve transparency, the lack of information and proprietary nature of their business makes both the recreation or replication of indexes and external verification difficult.

Last summer, investment management firm Vanguard mistakenly added shares of non-compliant companies, including a gun manufacturer and a private prison operator, to its largest socially responsible ETFs, mimicking an error in the FTSE Russell benchmarks they track. Once identified, the issue was rectified and clients informed of the constituent changes, but the incident highlights the problem that exists with complexity and transparency.[4]

Active ownership challenges

The rise in assets under management invested under passive strategies has also raised questions about what the impact will be on the governance of listed companies due to the concentration of shareholder power among a small group of passive investors. Large firms Blackrock, Vanguard, and State Street together now hold about 25 per cent voting power across the S&P 500, and about 22 per cent across the Russell 3000.[5]

A combination of a lack of resources and the large numbers of holdings in passive funds means research on proxy votes is often “outsourced” to third parties such as proxy voting agencies, diminishing this important part of shareholder responsibilities. It has also been argued that large institutional investors with diverse portfolios and large numbers of holdings, such as those investing in passive strategies, are not adequately incentivised to undertake ESG engagement with investee companies. The economic benefits involved can be minimal due to the relatively small size of each individual holding. Additionally, the costs of engaging with a diverse, widely spread portfolio may also be cost prohibitive. That said, times may be changing when it comes to passive investors holding corporations accountable.

Larry Fink, the founder and chief executive of investment firm BlackRock, recently penned a letter to the CEOs of the companies that his more than $7-trillion firm invests in, encouraging them to consider the societal implications of their business decisions and to focus on their long-term plans. Although he acknowledged that BlackRock cannot divest of companies in its index funds, which account for approximately three quarters of its assets under management, Fink makes it clear in his letter that the firm will more willingly vote against management and board directors when companies are not making sufficient progress on sustainability related disclosures, and the business practices and plans underlying them.

Charting a path towards industry best practices

Last year, the Principles of Responsible Investment (PRI) network published research and case studies focusing on the integration of ESG into passive, quantitative and smart-beta strategies, and last fall it launched an industry-wide consultation. The organization obtained feedback from PRI signatories and other interested stakeholders, with a view to producing further guidance on the subject.

This past March, the PRI released its findings in a report that highlighted next steps for asset owners, asset managers, and regulators. Below is a summary of some of their recommendations:

• Asset owners: encourage investment managers and data providers to report and disclose proactively on ESG index methodologies.
• For asset managers (and service providers): adopt more collaborative approaches to engagement; develop public approaches to systemic issues such as climate change and governance; ensure new financial products are constructed and marketed in a transparent and consistent manner; promote better corporate ESG data; and ensure that ESG rankings and scores are based on transparent and consistent processes, and that any changes to indexes or benchmarks are accompanied by clear explanations.
• Regulators: encourage clear and consistent reporting, and review acting-in-concert guidelines to ensure these do not prevent collaborative engagement.

Alongside these consultation results, the PRI has published a series of case studies to show good practice in the industry. It has also created a Passive Investment Reference Group, open to asset owner, investment manager and service provider signatories. In the coming months, the PRI intends to reflect on this consultation process and develop further guidance.

Readers can access the report here: ESG and passive investment strategies signatory consultation results