ESG integration in passive investing has grown dramatically in recent years. This growth has been driven by a variety of factors: a general increase in indexing, ETFs that provide benefits (e.g. cost and tax benefits, daily liquidity and transparency), and increased investor interest in ESG and sustainability.
Oftentimes, two funds with “ESG” in their names may have completely different sector exposures, integration methodologies, exclusions, and levels of concentration. The differences lie in the way they are constructed. ESG integration in passive investing still requires an active decision around the choice of ESG index and the methodology that underpins that index. In today’s market the question becomes: how do you compare ESG indexes and their ESG methodologies?
The first ESG index, now known as the MSCI KLD 400 Social index, was developed in 1990 by KLD Research & Analytics. Today, there are more than 1,000 ESG indexes1, a testament to the growth in sustainable investing. This proliferation is the result of several driving forces – increasing evidence of the correlation between the incorporation of ESG factors and enhanced risk-adjusted returns, a desire to reflect investor values in investment strategies, and increasing availability of ESG data.2 MSCI holds the market as the primary provider of ESG indexes, as well as the primary ESG research and data provider for the creation of ESG indexes.
According to Morningstar, in 2020, passive approaches and ETFs dominated sustainable fund flows.
29 of the 71 sustainable funds launched last year were ETFs, a big uptick from previous years.
With all of this growth, investors have more ESG ETF options to choose from. Adopting a passive approach through indexing and an ETF vehicle has benefits, including broad market exposure, lower costs, and more transparency. While actively managed ESG strategies may apply more qualitative insights, which can be more subjective and require further digging, the implementation of ESG information into index construction is typically clearly explained in the index methodology and in the prospectus of the ETF that tracks that index. The methodology is quantitative and rules-based, with defined ESG inputs and criteria.
Four things to think about to find the right passive ESG strategy
1. Determine investor goals. There are many flavors of sustainable investment approaches in passive investing, and identifying what the investor is trying to achieve will guide the process of narrowing down the universe. ESG indexes use ESG data to reflect certain values or ethical considerations, or to capture opportunities through an information advantage that ESG information may provide.
Is the investor aiming to allocate their dollars to more sustainable companies? Is there a particular theme they’re passionate about, such as water or diversity, or do they want to avoid investing in fossil fuels? There might be concerns around deviations in tracking error from a traditional market capitalization-weighted benchmark when incorporating ESG screens or tilts in the construction of an ESG index. Understanding the sources of concentration risk and tracking error are important components in selecting the most appropriate ESG ETF. There is a balance between the approach and the resulting tracking error.
2. Dig into the index methodology. ESG indexes are generally based on a parent index, which serves as the initial universe of securities. Then a set of ESG specific rules is applied to decide the constituents of the ESG index. The rules are executed with ESG data, and there are a multitude of ESG data providers. There are also many different ways to incorporate ESG data into an index methodology. Investment managers are increasingly constructing their own ESG scores underpinned by multiple ESG data providers, as well as their own proprietary research. In order to make informed decisions, it’s useful to understand which ESG data providers are reputable and what is considered best practice in constructing an ESG index methodology.
Source: How Can a Passive Investor be a Responsible Investor? UN Principles for Responsible Investment, 2020.2
3. Understand ESG data sources. A passively managed ESG strategy is heavily reliant on the quality of its ESG data inputs. Thus, the index provider and the ESG data providers selected become even more crucial to the process. While it’s improved substantially over the last 10 years, ESG information is not standardized and is subjective. Information disclosed by companies is voluntary and may be unaudited. Companies are still figuring out how to measure, track and disclose key ESG metrics. While ESG data providers that collect these metrics from companies add value by contributing their expertise to better evaluate and standardize this information, the quality of the underlying company reported data is limited and can be inconsistent. This is a particularly relevant for passive approaches to ESG integration, given the reliance on direct data inputs with this type of approach.
4. Remember passive investors are the ultimate long-term shareholders. To invest passively is to be a universal owner. It’s a buy and hold strategy. As such, there is incentive to improve the ESG practices of companies, to capture opportunities for enhanced corporate performance. This means corporate engagement on ESG issues is a natural extension for a passive investor. The engagement approach of a passive manager, and the effectiveness of that approach, should be crucially considered. However, engagement does come with a price. Passive investing was created with the intent to lower management fees, and fee compression is a prevalent trend in the industry. Comprehensive and extensive ESG engagement, which can be a multi-year endeavor, requires resources, which increases costs. In this case, and particularly for smaller asset managers, collaborative action can be an effective method of engagement.
At Envestnet PMC, we’re closely monitoring these aspects of ESG integration in passive investing. Over the last few years, we’ve built out a process to conduct ESG due diligence and a systematic way through a quantitative approach. This framework has four main components:
- Oversight & Accountability of ESG measures the firm-level governance of ESG practices and commitments, along with the firm’s ESG philosophy, policies, and general transparency around ESG processes and decision making.
- ESG Integration in the investment process evaluates the index construction methodology, the quality of ESG inputs, the ESG research and data leveraged, and the rigor of the approach.
- Reporting on impact: an assessment of how managers communicate the ESG outcomes of investments.
- Active ownership on ESG issues looks at the engagement approach, policies and processes, how progress on ESG engagements are tracked over time, and how success is measured.
“ESG” in the name of an ETF can mean many different things, but, executed well, ESG integration can add demonstrable value in the investment process. Envestnet PMC is here to support you in identifying managers that are meaningfully integrating ESG information in unique and compelling ways in the pursuit of better outcomes for your clients.
- Sarah Kjellberg, Tanvi Pradhan, Thomas Kuh, “An Evolution in ESG Indexing,” Blackrock, https://www.ishares.com/us/literature/whitepaper/an-evolution-in-esg-indexing.pdf
- Toby Belsom, Catherine Chen, Kris Douma, Marisol Hernandez, Felix Soellner, “How can a passive investor be a responsible investor?” PRI: Principles for Responsible Investment, https://www.unpri.org/download?ac=6729
- “Sustainable Funds U.S. Landscape Report,” Morningstar, https://www.morningstar.com/lp/sustainable-funds-landscape-report
The information, analysis and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.