SI Dilemma: Active versus passive SI?

Last month the index giant MSCI announced that it would remove ‘ESG’ from the title of several of its widely used ESG index groups, including the ESG Leaders index, which is a popular choice for passive ESG funds. The decision was a consequence of ESMA (European Securities and Markets Authority) fund-naming guidelines and shone a light on passive SI approaches as many investors with funds tracking this benchmark questioned whether their passive funds could still be considered sustainable.

Passive SI strategies grew rapidly in the years leading up to 2021, mirroring the trend in the broader market, and influenced by factors such as lower fees and complexity, accessibility and consistency of returns. Yet, passive portfolios still make up a smaller proportion of SI assets under management (around 25%) than of non-SI AuM, where passive strategies now exceed active in some areas. Here are some of the reasons we think contribute to this difference.

Passive investments typically track an index. While conventional indices are constructed based on objective measurable criteria such as market capitalization, ESG indices are usually driven by ESG data or ratings, which can be subjective or difficult to replicate systematically.

Ratings often vary considerably between providers depending on their methodologies, and even raw datapoints reported directly by companies suffer from comparability, measurability and standardization challenges.

Social issues such as a company's supply chain practices and labor conditions are especially likely to be evaluated based on subjective qualitative criteria, leaving them open to different interpretations. Active strategies may be better positioned to handle these nuances and construct a portfolio with higher conviction in its sustainability characteristics.

SI has evolved rapidly over the past two decades with increased disclosure, better understanding of climate science and the impact of broader ESG factors on companies and society, as well as changing social and regulatory attitudes toward sustainable industries.

While some benchmarks do try to adapt, as we have seen recently, the pace of change is naturally much slower than actively managed strategies that can quickly respond to new information, changing market conditions, and emerging sustainability trends.

This agility and ability to capitalize on opportunities more effectively is of course one of the general arguments in favor of active investing, but it is particularly relevant to sustainable approaches.

Active ownership is a core tenet of sustainable investing, being the second of the six UN Principles for Responsible Investment. Some studies suggest that passive investors are less likely to vote against management than active investors, perhaps due to the fact that the typically much more concentrated portfolios in active strategies allow for more research and attention being paid to individual companies. In other words, you get what you pay for.

Another school of thought suggests that investing passively and focusing efforts on engaging with companies to influence change is a more effective way to achieve sustainability goals than investing in actively managed portfolios. This seems more likely to work if the asset owner or manager is large enough to own a reasonable proportion of companies under engagement, and can afford the sometimes significant cost of meaningful engagement with company management.

Arguably, both of these approaches have merit, and perhaps the method of engagement matters less than whether it is actually being done in a meaningful way.

In recent years, enhanced index strategies have grown in popularity, combining elements of passive index tracking with some active inputs to try and optimize returns, or optimize factors such as sustainability inputs or characteristics.

Advancements in data availability and quantitative analysis have helped drive this growth, and the emergence of sophisticated AI tools is an exciting avenue for future development. These approaches can be helpful from both a financial materiality perspective – using ESG criteria to optimize returns potential – and an impact materiality lens – tilting portfolios to align with sustainability goals – and by optimally combining the two lenses.

The choice of SI products across all asset classes has never been as rich and diverse as it is today, benefiting from broader financial product innovation. Interest in sustainability and the need for global action to channel capital to sustainable development also serve as drivers of such innovation.

To some extent, the idea that passive investing is an easy option for investors is a fallacy. All investment decisions are actively made, even the choice between active and passive or semi-passive approaches, and there is room for all approaches to meet the diverse needs of today’s investors.