Will ESG Investing Save Active Management?

Read 3 min

The active versus passive management debate is well documented, but with ESG or sustainable investing the debate takes on a new dimension.

The objective of an integrated ESG process is to enhance risk-adjusted returns by making sure ESG risks are explicitly incorporated in the investment process. For investors, the key question is what their desire to incorporate ESG factors into the investment decision does to the relative effectiveness of passive and active strategies.

Many investors choose passive funds because they are low cost, and we accept that ESG integration does little to move the needle on that one. For sure, ESG integration does not reduce fees on active funds –round one to the passives.

However, from this point on the passive approach, in our view, runs into serious trouble.

First, there is a fundamental issue with ESG data availability in the fixed income space. Typically ESG data is collected from publicly available report and accounts, which of course works well for quoted equity-based indices and investors. However, many bond issuers are unlisted, and as a result around one third of our funds’ holdings relate to issuers that are not represented in ESG databases, which requires us to carry out our own ESG research on these names. These are not unusual issuers in the fixed income world and can range from housing associations to utility companies. Indeed, if you want to apply this approach to asset-backed securities (ABS), as we do, then you are looking at doing all of the work yourself. So, for fixed income indices to incorporate ESG factors is a major challenge.

Investors who want their money to be responsibly invested expect their managers to engage with companies, regulators and government bodies on a range of issues. As fixed income investors we have no voting rights at AGMs, but we engage with the above bodies on behalf of our investors as and when required. This can be anything from negotiating the structure of a deal, to taking action if we feel an issuer is engaging in sharp practice to the detriment of our investors, to more generally asking issuers about their ESG policies. Some interesting recent examples would be Aviva and National Grid. Passive funds can effectively be forced buyers or holders of bonds (due to their requirement to match an index or benchmark), so they cannot effectively engage nor do they hold any effective sanction.

At TwentyFour we are big believers in ‘momentum’, which is assessing a company’s goals and deliverables in achieving better ESG outcomes in the near future. We think capital markets should support companies that are transforming themselves for the better, rather than taking a static snapshot and deciding the profile is not good enough. Imposing a hard screening rule may look and feel good, but ultimately we believe it is seeking and achieving better ESG outcomes that really matters.

We also pay close attention to ‘controversies’. For example, has a company had an avoidable accident or been guilty of reprehensible activity in the ESG space? We recently analysed a water company, and going by its accounts coupled with the Corporate and Social Responsibility report (CSR) you might have felt this company’s ESG credentials were excellent. Further digging however threw up all sorts of issues, such as fines for polluting rivers and a lack of funds to invest in reducing leaks because the company had borrowed to pay dividends to its shareholder. Again, not issues easily picked up by rule-based models or indices.

As active managers we would argue that rule-based passive funds are inferior to well managed active funds. When we begin to additionally look for a better future in terms of environmental and societal outcomes from our funds, we hope that those passive champions will realise that static fixed rules just don’t cut it. We know that passive funds will, at best, never beat the index they track, at least not by a significant margin – can we really afford such limited ambition for the outcomes of ESG or sustainable funds?

We believe the case for active management becomes overwhelming here. Passive funds simply cannot deal with the additional demands of ESG or sustainability goals.


About the author
Graeme Anderson

Graeme Anderson

Partner, Chairman & Portfolio Management

Blog updates

Stay up to date with our latest blogs and market insights delivered direct to your inbox.

Sign up