Why choose indexing for sustainable investing

But while both themes are in demand, combining them into a single suite of products is also a possibility.

Passive or index funds do not have to blindly buy all of the shares in an index, as smart beta strategies can be used.

Smart beta means giving greater preference to the stocks within an index that meet certain characteristics, and less preference to the stocks which do not. 

Smart beta products were initially created to allow passive exposure to volatility managed and income products, but in recent years products that give greater relative exposure to ESG criteria have come to market. 

Manuela Sperandeo,  EMEA EII head of sustainable indexing, at BlackRock says: “There is a misconception that index investing for ESG means complexity and opaqueness, but that is not the case, because a client can choose what type of sustainable outcome to go for.

"Sustainable indexing strategies range from simply screening out certain businesses, right through to overweighting companies with strong ESG ratings or financing projects with measurable environmental and social impact.

Adopting an indexing approach to sustainable investing offers transparency, clarity and control Manuela Sperandeo

"ESG as a set of preferences is evolving faster than any other segments of the asset management industry in my experience.”

She adds: “Adopting an indexing approach to sustainable investing offers several benefits, such as transparency, clarity and control. We work with the index providers to ensure new product solutions reflect investors’ preference with regard to sustainability.”

Nicolo Bragazza, investment analyst at Morningstar says that ESG index funds carry all of the same advantages as do non-ESG passive investments in terms of offering broad market exposure and low fees, and have abundant transparency around what they are invested in.

He says that a client who just wants a broad-based ESG portfolio will find that index funds fit the bill. 

But he says: “On the other hand, if investors have specific requirements in terms of engagement and/or want their investments to make a measurable impact, it is more likely for them to find what they look for in the active space, where managers have more flexibility in their investment decisions and policies." 

A spokesperson of passive investing firm Vanguard says: “Index funds have the advantage of enabling investors to hold balanced, broadly-diversified, portfolios at a low-cost.

"Those that follow ESG or SRI benchmarks then screen out companies that don’t meet agreed, independent ESG criteria, in a clear and transparent way.

"Nevertheless, it’s important to remember that definitions and approaches to ESG vary widely, as do opinions on the 'right' way to reflect ESG considerations in investments. This is unsurprising – there are a broad range of possible approaches, and people's personal values also differ.

"Nuclear power is a good example of an investment that investors across Europe have very different attitudes towards. When it comes to ESG investing it’s important for investors to do their due diligence, to make sure they are in products that align with their individual values.”

Amer Khan, European managing director of ESG consultancy firm Entelligent, says the next stage of development for ESG index funds will be the adoption of internationally-recognised definitions of ESG as this will lead to the creation of index portfolios aligned with those definitions, reassuring investors that the portfolios contain the types of investments they are happy with.

Mr Khan adds that ESG funds which merely seek to exclude certain investments are now “last year's news”, as the market moves in the direction of launching passive investment products which aims to include investments that have a positive impact on the world.

Jake Moeller, senior investment consultant at Square Mile research, says: "There are now an increasing number of responsible indices coming to market such as FTSE4Good.

"An investor really needs to appreciate the composition of these indices and feel comfortable with their methodology. If an index is exclusionary only, it may not tick a client’s sustainability objectives especially if they are more solutions-focused.

"A low carbon index which focuses on, say, carbon emissions as a percentage of revenues could potentially include a petroleum company. Investors really need to know the index inclusion/exclusion rules."

Rule breakers 

Barry Cowen, senior portfolio manager at Sanlam, a wealth management firm, says that as long as the product provider is clear about the types of investments that are held within the index fund, but says the rules need to be very specific in order to be effective.   

He says: “Index ESG funds require a specific set of criteria, rules, under which they invest. Such rules mean what they will and won’t buy should be fairly clear.

“So apart from a degree of qualitative interpretation, clear rules bring merits. ESG funds have been more niche and generally require additional oversight, including sometimes independent external committees.

"That means costs. So ESG product has to date, in general, been uncompetitively priced. ESG solutions thus appear more expensive, which may not sit well with a ‘positive outcomes’ mindset for some investors – why should I pay more to do the right thing?’

"Tracker ESG funds help. The downside is, ESG is highly qualitative. So broad rules may not provide the desired effect."

Charlie Parker, managing director at Albemarle Street Partners, a discretionary fund house says: “There is a growing industry of green indices and even now green gilts that are helping support investors who wish to invest ethically but still passively. This is emergent and investors must note that it necessarily introduces particular sector biases that will work at certain points of the cycle and not at other times.” 

But Mr Parker feels that a weight of capital has been deployed into a relatively small number of shares, and this has caused share prices of some of the most attractive stocks to rise; for this reason Mr Parker says he prefers to get his ESG exposure from actively managed products at this time.   

David Barron, head of index equity and Smart Beta at Legal and General Investment Management says that while indices can give investors a particular type of market exposure, the indices themselves are not a set of ESG rules, and so are just as likely to be just as subjective as are ESG portfolios put together by active fund managers.

David Thorpe is special projects editor of FTAdviser and Financial Adviser