switzerlanden
Passive investing and sustainability are incompatible

Passive investing and sustainability are incompatible

18-01-2019 | Insight

Sustainable investing requires active choices and so cannot be done purely passively, Robeco quant specialists say.

  • David Blitz
    David
    Blitz
    Head of Quant Research
  • Wilma de Groot, PhD
    Wilma
    de Groot, PhD
    Head of Core Quant Equities

Speed read

  • Passive funds buy the entire market without using ESG factors 
  • Sustainable indices are active, not passive strategies
  • Best of both worlds is possible with sustainable enhanced indexing

In a new note, David Blitz and Wilma de Groot argue that sustainability and passive investing are fundamentally irreconcilable investment philosophies, and investors must therefore choose one style or the other.

“One of the biggest investment trends over the past decades has been the shift from active to passive investing. The idea behind passive investing is that active management is a zero-sum game before costs, which implies that passively following the capitalization-weighted market portfolio at minimal costs should result in above-average performance,” says Blitz, co-head of Robeco Quantitative Research.

“Another very popular trend among investors is to make serious work of integrating sustainability considerations, such as environmental, social and governance (ESG) criteria, into the investment process. However, these twin desires are fundamentally at odds with each other: investors can have one or the other, but not both.”

Stay informed on Sustainable Investing with monthly mail updates
Stay informed on Sustainable Investing with monthly mail updates
Subscribe

Different incentives

“Intuitively, it may seem that sustainability considerations may be integrated effectively into a passive investment approach. Specifically, passive investors can do active voting and engagement, they can exclude the stocks that are most problematic from a sustainability perspective, or they can choose to passively follow an ESG index,” adds de Groot, portfolio manager for Robeco’s Core Quantitative equity team.

“However, because comprehensive sustainability integration involves many active decisions, it requires active portfolio management, active risk management and active performance evaluation techniques. As a result, investors find themselves in the active management space, whether they like it or not. Passive investing and sustainability integration are very different investment philosophies, and therefore difficult to unite.”

The authors say that while voting is possible for passive owners of shares, a recent study found that they sided with corporate management over 90% of the time.1 The business model of passive managers replicates the market index as closely as possible, and for that it does not matter if they vote or engage. Conversely, the main task of active managers is to generate added value, and active voting and engagement can be a powerful instrument for doing so.

They go on to argue that, apart from threatening firms with bad publicity, there is very little that passive managers can do if firms do not take their engagement efforts seriously. They cannot actually sell their positions in firms that only pay lip service to ESG issues because they are obliged to replicate the entire market portfolio.

Enhanced indices

Still, passive managers can offer to track a broad market index but then exclude the stocks that are most problematic from an ESG perspective. Popular targets for exclusion include ‘sin stocks’ such as tobacco and alcohol, or controversial companies such as cluster bomb makers. Increasingly, producers of thermal coal are being added to exclusion lists.

Performance deviations are likely to be small as long as the number of excluded stocks is limited, but this approach becomes increasingly difficult to achieve as the exclusion list grows. And it is entirely negative screening, so it does not allow for positive screening using ESG criteria, where what you include is as important as what you exclude.

Some passive investors believe that this issue can be solved by tracking an ESG index – one that consists only of stocks with the best ESG profiles. Although passive management techniques can be used to replicate the performance of such an index, it has all the characteristics of an active portfolio.

“What adds to the activeness of an ESG index is that the ESG profiles of firms change over time, and because ESG criteria themselves are also subject to change: what was deemed sustainable 20 years ago might not pass scrutiny anymore,” says Blitz.

Best of both worlds?

What, then, about an alternative solution: using an active sustainable approach that stays close to the passive market index? Wouldn’t this achieve the best of both worlds?

“At Robeco, we have extensive experience with efficiently integrating many kinds of sustainability requirements into investment portfolios, and the result does not have to be a very active portfolio,” says de Groot.

“Even when individual stock weights are not allowed to deviate much from the capitalization-weighted index, it is still possible to achieve a portfolio with a strong sustainability profile. A good example is the Robeco QI Global Developed Sustainable Enhanced Index Equities fund, which has an expected tracking error of just 1%.”

“The aim of this strategy is to deliver higher net returns than the MSCI World index by tilting the portfolio towards stocks with strong scores on proven quantitative factors, such as value and momentum. At the same time, the strategy preserves the main benefits of passive investing, by offering a highly diversified portfolio at low costs.”

Updated on 16 January 2019. This article was initially published in September 2018

1Fichtner, J., Heemskerk, E.M. and J. Garcia-Bernardo, 2017. “Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk.” Business and Politics, Vol. 19 (2), pp. 298-326.

Important legal information

The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.

The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.

Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is ACOLIN Fund Services AG, Affolternstrasse 56, 8050 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult www.finma.ch for a list of FINMA registered funds.

Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/RobecoSAM AG product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/RobecoSAM AG offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.

This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.

I Disagree