Active versus passive investment in achieving sustainable development

Active versus passive investment in achieving sustainable development

Growing investor concerns about climate and societal crises have contributed to the burgeoning demand for ‘sustainable investment’ funds that take into consideration environmental, social and governance (ESG) factors.

Download PDF version

According to Morningstar, sustainability funds attracted USD20.6 billion1 of new assets globally in 2019, almost four times higher than the previous year. This should be a positive development, as more capital should, in theory, be channelled into helping resolve some of the world’s greatest challenges. However, this may not necessarily be the case as not all sustainability funds are created equal.

The biggest differences occur between active and passive funds, and more specifically, in how they assess ESG factors, and how they engage with companies. Passive investing typically uses quantitative ESG data, procured from third-party providers, to either exclude companies or tilt a portfolio towards more ‘sustainable’ companies, or a mixture of both. Active investment involves picking individual stocks and bonds based on an assessment of their underlying fundamentals, and either uses qualitative or quantitative ESG analysis, or often both.

Many questions remain about the validity of ESG metrics, including a lack of standardisation in the data, and the overall scoring methods being used. For example, in 2018 three well-known and highly regarded services came up with completely different ratings for Tesla on ESG issues. FTSE rated Tesla as the worst car maker globally based on its metrics, MSCI ranked it the best and Sustainalytics was roughly in the middle. Moreover, it is common to find that the top-rated businesses on ESG issues also tend to be larger, developed market companies, suggesting the data is skewed to large capitalisation firms that have more formalised policies and more transparent disclosure.

Using quantitative ESG data can be beneficial in some circumstances, but placing too much emphasis on ‘ESG by numbers’ can be a risky strategy. It also is unlikely to fulfil the desired outcome of shifting capital toward more productive purposes. A quick glance at the constituents of the Dow Jones Sustainability World Index, BlackRock iShares ESG ETFs or the FTSE4Good Index, reveals the familiar names of Apple, Google’s parent Alphabet, and Bank of America. These businesses offer useful products and services, but are they really the most sustainable businesses in the world?
To invest in the highest quality companies that both contribute to and benefit from sustainable development, there needs to be room for qualitative judgements, on more nuanced areas such as:

  • Are the products and services useful, and making a valuable contribution to society?
  • Is the company genuinely trying to improve its approach to sustainability rather than just greenwashing?
  • Is the company able to navigate sustainability headwinds and tailwinds (e.g. changing consumer preferences or regulations)?
  • How is the company’s corporate governance?In other words, how does it treat various constituents – shareholders, employees, customers?

It is not easy to find answers to these questions in ESG data alone, and it is difficult to ascertain when investing in hundreds and sometimes thousands of companies. Genuinely active investment managers, with high active share and more concentrated portfolios, should be better placed to assess these grey areas and therefore make more considered and conscious judgements.

Engagement is another important difference. For passive funds the approach to engagement can be limited by the breadth of their portfolios and is often conducted by groups that are separate from the investment team. In these cases the highly diversified nature of passive funds can work against effective stewardship. Long-term active investors that hold stocks for five years or more have the opportunity to build relationships over time helping them to influence corporate policy and encourage better practices.

Proxy voting also provides an opportunity for investors to encourage businesses to improve their ESG performance. Research finds that active investors are more likely to hold management to account by voting against them on proxy ballots, versus passive investors who are more likely to vote in line with management. For example, BlackRock, Vanguard and State Street, the three largest passive firms all supported doubling the pay of the CEO at California utility PG&E Corp even after its stock plummeted over the USD30 billion liability from maintenance problems linked to the California wildfires. The firm has since filed for bankruptcy, becoming one of the largest utility bankruptcies in history, and one of the first to be tied directly to climate change. Even worse, recent research found a number of large passive investors have repeatedly voted against resolutions related to the environment or climate change at annual shareholder meetings even as they publicly call on companies to consider climate risks.

It seems that when it comes to sustainable investment, there is an argument that you get what you pay for, with passive funds offering a cheaper, simpler product, versus active funds that can provide more in-depth and considered analysis. All sustainability funds, regardless of whether they are active or passive, need to be clear and transparent about how they are delivering on their sustainability promises, lest the industry once again finds itself the subject of criticism for failing to meet clients’ needs and expectations.

1 Source: https://www.morningstar.com/articles/961765/sustainable-fund-flows-in-2019-smash-previous-records

Investment terms

View our list of investment terms to help you understand the terminology within this document.

Subscribe to our updates

To get regular updates and content from Stewart Investors, please register here.

Important Information

This material is for general information purposes only. It does not constitute investment or financial advice and does not take into account any specific investment objectives, financial situation or needs. This is not an offer to provide asset management services, is not a recommendation or an offer or solicitation to buy, hold or sell any security or to execute any agreement for portfolio management or investment advisory services and this material has not been prepared in connection with any such offer. Before making any investment decision you should consider, with the assistance of a financial advisor, your individual investment needs, objectives and financial situation.

We have taken reasonable care to ensure that this material is accurate, current, and complete and fit for its intended purpose and audience as at the date of publication. To the extent this material contains any measurements or data related to environmental, social and governance (ESG) factors, these measurements or data are estimates based on information sourced by the relevant investment team from third parties including portfolio companies and such information may ultimately prove to be inaccurate. No assurance is given or liability accepted regarding the accuracy, validity or completeness of this material and we do not undertake to update it in future if circumstances change.

To the extent this material contains any expression of opinion or forward-looking statements, such opinions and statements are based on assumptions, matters and sources believed to be true and reliable at the time of publication only. This material reflects the views of the individual writers only. Those views may change, may not prove to be valid and may not reflect the views of everyone at First Sentier Investors.

To the extent this material contains any ESG related commitments or targets, such commitments or targets are current as at the date of publication and have been formulated by the relevant investment team in accordance with either internally developed proprietary frameworks or are otherwise based on the Institutional Investors Group on Climate Change (IIGCC) Paris Aligned Investment Initiative framework. The commitments and targets are based on information and representations made to the relevant investment teams by portfolio companies (which may ultimately prove not be accurate), together with assumptions made by the relevant investment team in relation to future matters such as government policy implementation in ESG and other climate-related areas, enhanced future technology and the actions of portfolio companies (all of which are subject to change over time). As such, achievement of these commitments and targets depend on the ongoing accuracy of such information and representations as well as the realisation of such future matters. Any commitments and targets set out in this material are continuously reviewed by the relevant investment teams and subject to change without notice.

About First Sentier Investors

References to ‘we’, ‘us’ or ‘our’ are references to First Sentier Investors, a global asset management business which is ultimately owned by Mitsubishi UFJ Financial Group. Certain of our investment teams operate under the trading names FSSA Investment Managers, Stewart Investors, RQI Investors and Igneo Infrastructure Partners, all of which are part of the First Sentier Investors group.

We communicate and conduct business through different legal entities in different locations. This material is communicated in:

  • Australia and New Zealand by First Sentier Investors (Australia) IM Ltd, authorised and regulated in Australia by the Australian Securities and Investments Commission (AFSL 289017; ABN 89 114 194311)
  • European Economic Area by First Sentier Investors (Ireland) Limited, authorised and regulated in Ireland by the Central Bank of Ireland (CBI reg no. C182306; reg office 70 Sir John Rogerson’s Quay, Dublin 2, Ireland; reg company no. 629188)
  • Hong Kong by First Sentier Investors (Hong Kong) Limited and has not been reviewed by the Securities & Futures Commission in Hong Kong. First Sentier Investors, FSSA Investment Managers, Stewart Investors, RQI Investors and Igneo Infrastructure Partners are the business names of First Sentier Investors (Hong Kong) Limited.
  • Singapore by First Sentier Investors (Singapore) (reg company no. 196900420D) and this advertisement or material has not been reviewed by the Monetary Authority of Singapore. First Sentier Investors (registration number 53236800B), FSSA Investment Managers (registration number 53314080C), Stewart Investors (registration number 53310114W), RQI Investors (registration number 53472532E) and Igneo Infrastructure Partners (registration number 53447928J) are the business divisions of First Sentier Investors (Singapore).
  • Japan by First Sentier Investors (Japan) Limited, authorised and regulated by the Financial Service Agency (Director of Kanto Local Finance Bureau (Registered Financial Institutions) No.2611)
  • United Kingdom by First Sentier Investors (UK) Funds Limited, authorised and regulated by the Financial Conduct Authority (reg. no. 2294743; reg office Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB)
  • United States by First Sentier Investors (US) LLC, authorised and regulated by the Securities Exchange Commission (RIA 801-93167)
  • other jurisdictions, where this document may lawfully be issued, by First Sentier Investors International IM Limited, authorised and regulated in the UK by the Financial Conduct Authority (FCA ref no. 122512; Registered office: 23 St. Andrew Square, Edinburgh, EH2 1BB; Company no. SC079063).

To the extent permitted by law, MUFG and its subsidiaries are not liable for any loss or damage as a result of reliance on any statement or information contained in this document. Neither MUFG nor any of its subsidiaries guarantee the performance of any investment products referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of MUFG or its subsidiaries, and are subject to investment risk, including loss of income and capital invested.

© First Sentier Investors Group