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Passive Fund Providers Taking an Active Interest in ESG

Institutional investors are increasingly aware of the positive impact of ESG integration and active ownership practices

Hortense Bioy, CFA 10 August, 2017 | 12:04PM

Passive managers are no longer treating stewardship responsibilities as a “box-ticking” exercise, but are actively looking to influence investee companies and improve ESG standards across the board. They vote and engage directly with companies on prominent issues like executive pay, board diversity and climate change.

The seemingly unstoppable rise of passive investing has been raising questions about the implications for capital allocation and corporate governance. Critics say that by owning every company in an index, passive investors don’t care if company A does better than company B, or whether sector C does better than sector D. This lack of discrimination could lead to inefficient capital allocation, with money flowing into companies that don’t deserve it.

One way of mitigating some of that risk is for investors to make sure that passive-centric asset managing firms adequately monitor the companies they hold on their behalf. The good news is that this is exactly what some of the largest groups are now committed to doing.

Moving in the Right Direction

There has been a clear shift in recent years, primarily driven by large asset owners. Institutional investors are increasingly aware of the positive impact that ESG integration and active ownership practices can have on investment performance.

Regulators have contributed further with the adoption of stewardship codes in several countries, including the UK, Switzerland and most recently Japan.

Another factor fuelling the behaviour change of passive fund managers is the tremendous growth of the assets they manage. Assets in traditional index funds and exchange-traded funds, or ETFs, have grown four-fold since the financial crisis, and nowadays represent nearly a quarter of total fund assets globally, according to Morningstar data.

The role of passive managers as active owners is all the more important in that they are the ultimate long-term shareholders of listed companies. Unlike active funds, which can simply sell a stock when they disagree with the way a company is run, index-tracking funds can’t sell. And precisely because of this, not least if they want to see their assets grow in what is increasingly becoming a low margin business, passive managers have every reason to ensure that all companies do well.

To that effect, some firms have beefed up their teams of corporate governance specialists. For example, BlackRock has grown its team from 20 members in 2014 to 31, while Vanguard’s investment stewardship team has more than doubled since 2015, reaching 21 people, on top of which it is presently adding a dedicated research and communications team.

Not All Providers are Waking Up to ESG

That said, one shouldn’t assume that all passive managers undertake stewardship activities in the same way and at the same level. There are differences stemming not only from the size and capacity of the firms, but also their philosophy, geographic scope and history.

When it comes to engagements, some firms are more proactive than others. Some are also able to draw on the knowledge of their in-house active portfolio managers, while others, lacking internal resources, rely heavily on third-party service providers. The focus of engagement may vary greatly as well, with some groups focusing almost exclusively on governance aspects, while others have policies in place that also address social and environmental issues.

Given the importance of responsible investing and growing investor interest in ESG considerations, one can only expect stewardship practices to be more closely scrutinised. Asset managers with a sizeable passive business won’t escape that scrutiny. In fact, they may find themselves especially singled out.

A version of this article was first published in Investment Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive fund research in Europe.