We believe that the most effective way to truly meet our clients’ objectives is by working with active managers. By leveraging their expertise, we aim to deliver the right outcomes for our clients: outcomes that we don’t think can be achieved through passive instruments.
In our opinion, there are three key reasons as to why passive ESG funds fall short in comparison to active ones.
Looking forwards rather than backwards
The subjectivity of ESG analysis, in our view, warrants active management. Being able to understand, digest and apply the non-financial factors involved within comprehensive ESG integration requires expertise: it is not just a case of gathering available data, but actively deciphering what is material to investment returns, identifying opportunities and mitigating risks. This is a key advantage for active managers, who can assess the future trajectory of a company, unlike a passive manager or instrument that is reliant on backwards-looking third-party data: investing through the rear-view mirror, rather than looking forward.
Differences between ESG rating providers
The foundation of passive investing is built upon the measurement of objective characteristics, resulting in a low-cost solution. This is potentially attractive to investors generally, but for those who are seeking ESG-integrated solutions, passive ESG options don’t necessarily fit the brief. Passive ESG funds utilise ESG ratings to help determine inclusion within the index that they track. Therefore, the objective nature of the passive investment is undermined and replaced with an active overlay that is dependent on the ESG rating provider that is selected. To further confuse matters, there is little correlation between ESG ratings delivered by the different providers; reducing complex analysis and evaluation into a single rating has its limitations.
The United Nations Principles for Responsible Investing (PRI) recently published some research carried out by independent academics that illustrates the differences between ESG rating providers. These researchers calculated pairwise correlations between six ESG data providers for the total ESG rating, and separately for the Environmental, Social, and Governance components. In their study, they conclude that there is “substantial disagreement” between ESG rating providers.
The chart above, published on the PRI website, outlines the average, minimum, and maximum pairwise correlations found in the study. This demonstrates the differences that can be found within a sample size of just six ESG rating providers – with an average pairwise correlation of below 0.5 across all four components.
By adhering to these ratings, passive ESG funds lose both their objectivity, being dependent on the active overlay of the rating, and their consistency, due to the substantial differences between the ESG ratings themselves. Active ESG funds, on the other hand, have no such limitations – in carrying out their own complex analysis and evaluation, active managers are able to make their own decisions around inclusions, rather than relying on a single rating.
The value of active engagement
To add to this, a somewhat undervalued tool that should sit within an ESG funds tool kit is active engagement. Passive managers are trying to illustrate progress in this area, yet we firmly believe that effective engagement is best wielded by active managers. This is a key ‘value-add’ for their investors, as managers actively engage on ESG and Sustainability issues on their behalf: promoting not only financial returns for their investors, but also helping them to achieve their non-financial objectives.
One example where we have seen this in action is within our Japanese equity allocation. Both of our current fund managers utilise active engagement to identify investment opportunities by specifically targeting companies that are willing and able to improve their ESG credentials. The fund managers help to guide these companies, setting them goals and targets to achieve with the aim of making them better corporate citizens. This approach has also yielded strong investment returns in the process.
Digging deep underneath the bonnet and analysing the philosophy and process of the investments you select is important if you are to align both your financial and non-financial objectives. Comparing financial returns is a simple process, but assessing if the non-financial objectives and expectations have been met is much more difficult. It is more complex than simply assigning a binary score, which is just a snapshot in time. The subjective nature of ESG allows for different interpretation and conclusions; as a result, not all ESG analysis is created equal.
Investment Manager, Head of Socially Responsible Investing (SRI)
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