Active V Passive: Which Strategy Is Better Suited To ESG Investing?

According to Morningstar, the BlackRock ACS World Low Carbon Equity Tracker fund saw net inflows of £700m in January, the largest single ESG investment, despite counting Nestlé - known for its association with various water-related scandals - as a top ten holding.

Bård Bringedal, CIO of equities at Norwegian financial services firm Storebrand, attributed the success of passives in the ESG space to the passives industry being "better at marketing than effectively integrating ESG into investment processes."

However, BlackRock's Marta Jankovic, EMEA head of iShares Sustainable, described the active versus passive management debate as "outdated".

"The word 'passive', which is often used interchangeably with indexing investing, conjures a dormancy that does not truly reflect the wide variety of active ways that investors use ETFs and index funds to take control of their investment outcomes," she said.

David Lake, CEO of ETF provider Lyxor UK, suggested the passive model is actually better suited to SRI investing due to its "transparency, simplicity and accountability", which allows investors to see exactly what is being invested in and what is avoided.

But some in the industry question whether the indexing model is suited to ESG investments, going so far as to suggest a "truly ethical client" would not want to invest in an ETF.

Harry Thompson, fund manager at King & Shaxson Ethical Investing, said: "We are rather critical of passives when it comes to sustainable investing as the 'human' element is removed, replaced by a benchmark-driven approach, where in many cases some of the underlying benchmark constituents fall short of client's sustainability criteria.

"In fact, we would go further and say passive investment has led to less governance and shareholders becoming divorced from their investments."

However, with 21% of European sustainable fund assets in passives, Morningstar's Hortense Bioy, director of passive strategies and sustainability research, suggested that sustainability and passive funds "should not be at odds", an opinion supported by the new ShareAction report on responsible investing, which stated "being a passive investor is not a barrier to having a leading responsible investment approach".

One of the biggest challenges for passive investing is an overreliance on ESG ratings, Bioy highlighted, which is connected to concerns regarding a "lack of consistency and availability of corporate ESG data".

This lack of consistency across ESG ratings has raised awareness of the subjectivity in ESG investing, which Mash Patel, CEO of Kurtosys Systems, has suggested may remain a concern "forever".

"Where ESG investing requires a degree of discretion, it is misleading to label passive investments as ESG," he said.

Furthermore, the task of analysing the enormous number of holdings a passive house may hold across its business is "simply not possible", according to

Eoin Murray, head of investment at Federated Hermes.

This apparent inability to have a full awareness of an index's constituents can lead to oversights, such as when Vanguard's 'gun-free' ETF was revealed to actually hold a number of gun stocks last year.

Investment stewardship is another key challenge for the passive industry; if managers are not always aware of the companies they hold they "cannot possibly engage with every single portfolio holding" due to their resource constraints, according to Morningstar's Bioy.

However, Howie Li, head of ETFs at Legal & General Investment Management, which is the only majority-passive management firm to receive an 'A' rating in the aforementioned ShareAction report, argues that the indexing model gives firms an even greater potential to engage.

"As long as we own it, it is going to our corporate governance team to analyse and when it comes time to vote, if there are bad practices in terms of governance, excessive pay, lack of diversity on boards or poor policies on climate change, they will vote against them.

"Imagine how much weight a $1.2trn firm carries. You hold a lot of weight and are able to actually make a difference when you vote."

Those in the active camp suggest that while the industry continues to question the efficacy of passive ESG investing, active management has the potential to mark itself as a sustainable leader.

Ketan Patel, fund manager at EdenTree Investment Management, said: "Active management will be at the core of long-term investing in large part because it addresses the very shortfalls of passive investment."

Federated Hermes' Murray described engagement as "a source of idiosyncratic alpha that cannot be systematically replicated by passive or quantitative managers".

He added: "Active management will be strengthened by making better use of the power of engagement and proper stewardship, but it is likely there are still too many mediocre active managers and that the field will see further consolidation."