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.”
“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.
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.