Passive managers are increasingly interested in ESG

Hortense Bioy

Hortense Bioy

The seemingly unstoppable rise of passive investing is raising more and more questions about its implications for capital allocation and corporate governance. Critics say that by owning every company in an index, passive investors do not care if firm A does better than firm B, or whether sector C does better than sector D. This lack of discrimination could lead to inefficient capital allocation, with money flowing into companies that don’t deserve it.

One way of mitigating some of that risk is for investors to make sure that passive-centric asset management firms adequately monitor the companies they hold on their behalf. The good news is that this is exactly what some of the largest groups are now committed to doing. 

Passive managers are no longer treating stewardship responsibilities as a ‘box-ticking’ exercise, but are actively looking to influence investee companies and help improve environmental, social and governance (ESG) standards across the board. They vote and engage directly with firms on prominent issues such as executive pay, board diversity and climate change.

As a result there has been a clear shift in recent years, primarily driven by large asset owners. Institutional investors are increasingly aware of the positive impact that ESG integration and active ownership practices can have on investment performance. 

Regulators have contributed further with the adoption of stewardship codes in several countries, including the UK, Switzerland and most recently Japan. 

Another factor fuelling the behavioural change of passive fund managers is the tremendous growth of the assets they manage. Assets in traditional index funds and ETFs have grown fourfold since the financial crisis, and now represent nearly a quarter of total fund assets globally, Morningstar data shows. 

The role of passive managers as active owners is all the more important in that they are the ultimate long-term shareholders of listed firms. Unlike active funds, which can simply sell a stock when they disagree with the way it is run, index-tracking vehicles can’t sell. It is precisely because of this that passive managers have every reason to ensure all the companies do well, not least if they want to see their assets grow in what is increasingly becoming a low-margin business. 

To that effect, some firms have beefed up their teams of corporate governance specialists. For example, BlackRock has increased its team from 20 members in 2014 to 31, while Vanguard’s investment stewardship team has more than doubled since 2015, reaching 21 people, on top of which it is adding a dedicated research and communications team. That said, it shouldn’t be assumed that all passive managers undertake stewardship activities in the same way. There are differences stemming not only from the size and capacity of the firms, but also their philosophy, geographic scope and history. 

When it comes to engagements, some firms are more proactive than others. Some are also able to draw on the knowledge of their in-house active managers, while others, lacking internal resources, rely heavily on third-party service providers. The focus of engagement may vary greatly, with some groups focusing almost exclusively on governance aspects, while others have policies in place that address social and environmental issues.

Given the importance of responsible investing and growing investor interest in ESG considerations, we expect stewardship practices to be more closely scrutinised. Asset managers with a sizeable passive business won’t escape that scrutiny. In fact, they may find themselves especially singled out.