What are the advantages and disadvantages of active management for sustainable investing?
There’s not much of a difference on how we approach investing with an ESG focus versus traditional active funds.
But I think the active management can grab ground against passive because passive investments follow an index. ESG ratings are not the “holy grail” and are criticized by academia and others. The data isn’t highly correlated—a company can score well on one index and poorly on another. It’s still a very young field.
Active managers who have time, resources and options can dig deeper and get better solutions for client outcomes. They can actively work with companies they are invested in with regard to improvement.
I definitely think active shareholder engagement is a virtuous circle. No corporation is perfect. There are always angles that could be improved, or new innovation comes to the plate.
What kind of investor is active management best suited to?
If you are very short-term oriented, costs matter a lot to you and you link returns to benchmark performance, then you are better suited to investing passively. On the other hand, if you have a longer time horizon—years instead of quarters—and you are willing to go through cycles with managers because their approach is in sync with your principles, then active management is better suited to you.
What about risk and return?
There are lots of academic studies of traditional fixed-income or equities portfolios compared with ESG portfolios and we can expect the same risk/return profile. Dependent on the type of ESG portfolio, that can vary.
Assume you have an ESG fund investing in companies that have products and services to address problems like climate or health. Those companies typically are smaller and pure plays. So you might have a portfolio that is overrepresented with smaller companies. Typically, smaller companies give higher returns but are also more volatile.
Some portfolios focus on ESG leaders—the best-rated stocks from each sector. They tend to have a quality tilt rather than a value factor. Now with the COVID-19 crisis, we see ESG leaders have higher quality and have held up slightly better than traditional portfolios.
The point why investors are integrating ESG in their portfolios is they are doing a more holistic assessment of the companies.
Are all asset classes suitable for active management?
There are of course equities and fixed income in developed and emerging markets. Active managers make selections, and the amount of choices is important. On the equity side, when you have very, very concentrated markets dominated by just a few stocks, it is hard for active managers to succeed.
With the private market, active management is the only way to go because of the availability of data. High yield is typically supported for active management because a lot of bonds are not traded. On the other hand, when you only have a few issuers—so, in the ESG space, that’s multilateral development banks like the World Bank—you can only buy a couple of bonds and you can question whether active management is valuable.
How do active managers find opportunities?
It’s a question of how many people are involved in the process, the resource capabilities and research budgets they have. Traditional idea generation has in the past been focused on sales-side research—from brokers and investment banks. Good ESG investors do a lot of research beyond Wall Street and sales-side research. They do company visits; attend conferences. For non-financial aspects, some are very well connected to think tanks, academia, industry groups and nonprofit organizations to find out certain aspects of the supply chain, for example. Media can play a role.