Published: 04th December 2020 (5 Min Read)

Ok, I am a dyed-in-the-wool active investor, so I have my biases, but let me walk through the issues as I see them. I shall also try to find some mitigating arguments for the index-oriented investor.

For what follows I am taking a long-term investor’s position. ESG issues are long term in nature, and so that is the logical starting point.

Sustainable investing seeks to invest in future changes for the better. Much of the future will be shaped by how we deal with new and evolving risks, and we are in a period of dramatic disruption.

  1. Index-based investing styles can show clearly their risk and return outcomes in financial terms.
  • It is not clear that they can show how they add to the achievement of social or environmental goals.
  • Sticking close to a benchmark may help with tracking error but how does it help achieve societal goals?
  • ESG investors want to know how their money is helping the planet and other people.
  1. Benchmark investing locks you into what became big in the past
  • This may not be true to the same degree when one is looking at a narrowly focused sector which is dominated by businesses which are emerging to deal with challenges. The Cloud for example, or medical cannabis or the energy storage supply chain.
  • But for the vast majority of their investment universe, it is based on historic data which often blindly combines the winners and losers of the future in equal (or index-weighted) measure simply because they were the winners or losers of the past.
  • Future change cannot be back-tested
  • This might be mitigated by basing passive investing upon a sustainability rating or index – but how do you choose which one? The have a weak correlation with each other, so how do you know what you are getting?
  • How does an adviser explain that to a client?
  • Even if a passive fund re-balances regularly it has to wait until the next date to adjust for ESG factors. With no company specific analysis, it cannot mitigate that risk with an understanding of internal corporate dynamics or potential change
  • Ratings simply recycle the past, rather than exploring which factors are at risk
  1. Underlying data and impacts are obscure
  • Passives are not created to provide high levels of component-level disclosure
  • Many ratings agencies wish to protect their intellectual property so they may not disclose the causes of changes in their ratings
  • Their intent may be clear, but how do you reassure yourself that they are doing what you want?
  • They cannot show that their methodology has contributed to solutions
  • This is a problem for an investor seeking to have a positive impact
  1. Complexity is not helpful to a goal-oriented private investor
  • Many people we talk to feel very strongly about some corporate activities but less so about others. Complex, ratings-based, approaches do not make it easy to observe the clear non-financial outcomes.
  1. Engagement requires active analysis
  • Much of future value creation is derived from investors observing possible improvements within companies, and then engaging with management to achieve such outcomes.
  • This can only be done by active investors
  • Active investors can escalate issues more easily because they can divest in extremis.
  • When investors combine with each other to pursue a specific outcome, even the largest companies pay attention.
  1. Voting requires dealing with individual holdings, not an index
  • How can anyone vote if they have not analysed the company?
  • This is an important component of sustainable investing.
  1. Passives often have a large cap bias
  • Large cap companies have a huge role to play, but the best-in-class operators are often SMEs – at least at the outset.
  • SMEs often do not have the resources to make the quality of disclosure which larger organisations can, and thus get excluded for the failure to disclose. Active managers can see through this
  • Good active managers can also discern potential changes within large companies. Many such companies will have a major positive impact when they effect change, simply because of the depth of their resources, but this will not be true of all large companies.
  1. The path to a good rating is more important than the current rating
  • Orsted with its leading market position in wind turbines is now a darling of the environmental investment community, but it was once a coal miner.
  • On a more disappointing note, Boohoo was highly rated by some sustainable ratings agencies, but isn’t any longer
  1. Passives often underperform in a downturn as the baby gets thrown out with the bathwater because the managers have to sell everything proportionately.
  • Surely it is in a downturn that you want resilience.
  1. It looks likely that credibility in sustainable investing will require clear reporting on what impact a manager has made through its approach to investing. If you haven’t made positive choices for the future or engaged with management, or voted on the issues which are important, what do you have to report?

The ratings services are useful tools for identifying issues, but of themselves they do not help cause change.

We are in a period of dramatic change and disruption. There will be many turns in the road. Passive investing studies the road already travelled, not that which lies ahead.