Investing ethically via passives

There are certainly passive products available for investors which have an ethical or sustainable remit but whether they are indeed as low in price as other passive strategies is up for debate.

Unlike other asset classes and themes, there are some limitations when it comes to using passive strategies to get access to ethical and environmental, social and governance (ESG) investments.

In September, the MSCI launched the MSCI Factor ESG Target Indexes, which are designed to help investors incorporate environmental, social and corporate governance factors into their investment process.

New ways to invest ethically are being introduced all the time.

Much has been made of some passives beginning to incorporate underlying ESG criteria in order to create ethically sound passive products, but we believe this approach is inherently flawed.David Osfield

For many, and unsurprisingly it is usually those who work in the active management space, passive is not an effective or efficient way to invest ethically. 

David Osfield, co-manager of the EdenTree Amity International fund, acknowledges: “The active management industry is facing increased scrutiny that rightly questions the value-add of active managers, particularly those that consistently deliver sub-index performance with uncompetitive fee structures. 

“While the active versus passive debate is a much broader topic to consider, there is one area where I believe that active management has a definitive edge – ethical and sustainable investing.”

He explains: “Much has been made of some passives beginning to incorporate underlying ESG criteria in order to create ethically sound passive products, but we believe this approach is inherently flawed. 

“While it might be possible to apply certain ESG criteria to passive funds – specifically the exclusion of companies operating in certain industries, such as alcohol or tobacco production – the reality of constructing portfolios entirely from negative screening is that the approach is largely commoditised, more subject to factor imbalances, and lacks a more comprehensive framework to identify the opportunities that companies can offer.”

Active over passive?

John David, head of Rathbone Greenbank Investments, says when it comes to ethical investing he has not found the passive route as attractive as active.

“On balance, we feel active investment, backed by well-resourced and established teams, provides a better overall fit with many clients, who may be looking for their investment to avoid many of the companies that may otherwise find their way into passive investment strategies,” he notes.

But he recognises some products have been able to combine robust screens with lower ongoing costs. 

For example, passive investing via trackers and exchange-traded funds (ETFs) has grown dramatically, Mr David observes.

“While the size of the broader ETF market is huge, historically there have been very few ethical ETFs. This is now changing, and the likes of iShares and others are providing solutions for regional allocations to SRI ETFs in Europe, US, Asia and Japan. 

“These have been facilitated by the increased growth and demand for sustainable indices from the likes of MSCI,” he adds.

“In the UK, the FTSE4Good index has provided an opportunity for fund groups to offer investors trackers. ETFs are also increasingly providing one-stop solutions to thematic investing, such as clean energy, or water. So on the face of it, yes, it is possible to invest ethically via passives.”

The FTSE4Good Index Series was launched to measure the performance of companies demonstrating ESG practices and uses what is describes as “clearly defined” ESG criteria to do so.

Mixed response

Online platform Selftrade reports the number of customers investing in green and socially responsible ETFs via Selftrade rose by 237 per cent in 2017, compared to 2016.

Mark Taylor, chief customer officer at Selftrade from Equiniti, says: "For investors who want to spread their risk, there are now a number of options, with many mainstream providers offering ‘green’ funds that invest using a variety of criteria.

"It’s worth also considering ETFs; there are a number of low-cost equity and bond smart-beta products that track specific socially responsible investment (SRI) indices."

Ones that Mr Taylor likes include:

• iShares Euro Corporate Bond Sustainability Screened 0-3 year Ucits ETF (SUSE), for example, excludes debt from companies that are involved with controversial weapons, such as cluster bombs, land mines and chemical and biological weapons.
• UBS ETF World Socially Responsible Ucits ETF (USD) invests in some of the most well-known global companies including Microsoft Corporation, Procter & Gamble Co and Walt Disney Co.

While passive products usually go hand in hand with lower fees, there are some who question whether this applies to ethical passive products.

Investing ethically via passives is expensive, according to Gary Waite, a portfolio manager at Walker Crips.

Many investors use a core satellite approach, whereby they construct an investment portfolio allocating to mainstream assets and supplement it by adding ethical passive products in specialist areas.Gary Waite

“Some products are available but there’s very little choice – typically they’re small so have extra liquidity considerations and they are at a premium to ‘standard’ ETFs, despite a limited track record,” he says.

Mr David agrees that historically, fees have not been as competitive for ethical/thematic ETFs as they have for more conventional ETF products.

“This is beginning to change, but one should not assume that this route is always cheaper than some of the active funds,” he suggests.

His main issue though is with the strength of the screen or investment restrictions that apply in passive investing.

“Some of these are more robust and based on a mix of positive ESG criteria and value-based exclusion criteria. 

“For example, MSCI SRI indices avoid companies with over 5 per cent of revenue derived from gambling and all tobacco manufacturers, retailers, distributors and suppliers deriving over 15 per cent of revenue. 

“But others, including many mainstream ethical passives, have a more limited screen - Vanguard SRI Global includes Exxon and Royal Dutch Shell in its top 10, for example, and the FTSE4Good trackers have a large weighting to oil and gas (over 10 per cent to Royal Dutch Shell) and mainstream pharma,” he explains. 

“Within the thematic ETFs, we also have concerns over the limited size and number of company holdings within some of these products. It’s a case of knowing exactly what you are buying.”

Doing due diligence

For some, active stockpicking is a core part of the approach to investing sustainably and responsibly.

Amanda Young, head of responsible investing at Aberdeen Standard, warns that investing passively without the ability to actively select stocks could exclude large chunks of the universe.

“Passive ethical money faces greater volatility and will be very dependent on individual sector performance,” she notes.

“That said, there are a number of innovative products in the passive space, evolving to take into account ESG factors.

“For example, concerns about climate change resulted in the launch of the Legal and General Future World fund, a multi-factor global equities index fund that incorporates a climate ‘tilt’ to address the investment risks associated with climate change.”

But she points out there are no passive options for positive selection or impact investing so the passive approach does seem to be fairly prohibitive in the ethical space.

Mr Waite acknowledges there are ways to incorporate passives into an ethical or sustainable portfolio.

He suggests: “Many investors use a core satellite approach, whereby they construct an investment portfolio allocating to mainstream assets and supplement it by adding ethical passive products in specialist areas, such as clean energy or sustainability screened products.” 

Although there is evidence of innovation from passive providers, Mr Osfield believes there are still too many limitations.

He argues: "Ethical passive investing without this investigative engagement requires a high standardised level of disclosure from companies, which is not readily available in certain places, particularly outside of developed market large-cap companies.

"Until the level of disclosure becomes more ubiquitous, passive index trackers are less likely to be effective at ethical and sustainable investing. Furthermore, investors should stop looking at ethical investing as a box-ticking exercise that can be achieved through a high-level screening, rather focus on investing in companies that are fully embracing sustainability at their core."

eleanor.duncan@ft.com