InvestmentsDec 3 2020

Can ESG index fund managers engage in stewardship?

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Can ESG index fund managers engage in stewardship?
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The ultimate sanction any investor has if they are unhappy is to sell the asset. 

An investor may choose to sell as a result of feeling that the financial case for an investment is no longer valid; an investor with an ESG focus will also consider whether an investment continues to meet the sustainability criteria of their mandate.

By definition, index investors do not have this power, as they must own all of the stocks within its index, in proportion to each equity within the index.

Nicolo Bragazza, investment analyst at Morningstar, says: “Stewardship when it comes to index funds is more problematic than active funds and this is not because they do not have the possibility to do so, but more importantly because they have to track indices usually provided by third parties.

"Active managers have the ability to decide which company they want to buy at their full discretion and usually they know in advance the areas or topics where engagement has the potential to deliver better outcomes.

"More importantly, active managers may exit their investment if the company does not meet their recommendations. On the other side, passive funds do not have such flexibility in their investment decisions and so, this represents an important limitation as they cannot divest their investments.

In this manner, they may be less effective in their engagement effort. 

This inability to sell an unsuitable stock does not, however, hamper the ability of ESG investors to engage in stewardship, according to David Barron, head of Index Equity and Smart Beta at Legal and General Investment Management.

He says that companies which do not engage meaningfully with ESG issues will be excluded from indices, and as more cash gets placed into the funds which are created to track those indices, the outcome will be share price underperformance relative to those stocks which do pay attention to ESG considerations. 

He says that because product providers respond to investor demand, the indices which are created in future will be those that include companies that behave best on the issues that matter to clients.

Mr Barron says that as companies which are not engaging with ESG are left out of indices, the share prices of those companies would likely fall, as they would be excluded from ESG portfolios.  

Richard Whitaker, vice president, BlackRock Investment Stewardship, at BlackRock says: “Index investors are long-term investors; we use three tools at our disposal: thought leadership, engagement and voting.

"We have a large global team with regional presence speaking 17 languages, working in this area. We think this level of resource and expertise helps us promote our clients’ long-term interests.

The end client would take the money away from us if we didn’t use the voting power we have responsibly David Barron, legal & General Investment Management

"We undertook more than 3,000 engagements this year, a 50 per cent increase on last year. Voting is how we hold companies accountable when they fall short of our expectations; we opposed the re-election of over 5,100 directors this year."

Mr Barron says: “The end client, the person who trusts us with their money, they will hold us accountable. They would take the money away from us if we didn’t use the voting power we have responsibly.

"Index funds tend to be among the largest investors in listed companies, and that gives us a great deal of power to vote against company management. And because we are long-term investors, the company management know we will always be there making our points.”

A spokesperson at Vanguard says the company views itself as a “permanent” owners of a company in which it is invested, and so uses its voting power to achieve long-term change.

Barry Cowen, senior portfolio manager at wealth management house Sanlam, says that index investors power comes from their ability to say: “‘Either change as a business, or be sold, our rules demand it’ .

He adds that: “Such businesses can, and do, vote en masse, the same way any fund does or can. In the case of bond investing, where voting is less relevant, the power to drive down the cost of capital for good actors, remains.

"Indeed, given the vast sums that are invested in aligned vehicles, the power here could be very large. Drafting of and potential evolution of the rules is all important, to achieve the desired effects, but can be done.”

Charlie Parker, managing director at discretionary fund house Albermarle Street Partners, says index investors have a “responsibility” to use their voting power to drive change, but adds: “In recent years there has been huge progress made by the largest investors to inject real rigour to this process.

"Of course they lack the basic ability to threaten to disinvest so it is their ability to force change that is the priority. There is further to go here of course because whether you invest actively or passively you are still committing your money to enable somebody else to use that capital. Your moral duty is the same whatever label you give yourself.” 

Diversification 

Amer Khan, European managing director of ESG consultancy firm Entelligent, says that an inherent advantage of investing for ESG exposure via index funds is that a client’s exposure is much more diversified.

Therefore, if there is one business which behaves in a way which is not in line with the client's values, and is subsequently removed from the relevant index, the impact on a client’s portfolio will be less. This is because, as an index investor, they will own a broader portfolio than if the same thing happened within an actively-managed ESG portfolio, which would own far fewer investments.     

Edward Malcolm, head of  European ETF Distribution at JP Morgan Asset Management says that the scale of large ETF providers, especially if they also have an active asset management business, is a major advantage when it comes to influencing company behaviour. 

David Thorpe is special projects editor of Financial Adviser and FTAdviser