What are the advantages and disadvantages of passive management for sustainable investing?
The advantages and disadvantages resemble those in the traditional market cap space. Index funds are liquid—you can get in and out easily. They have high capacities—they can absorb large investment inflows quickly. Fees tend to be lower than for active funds. Investors are very comfortable with index funds.
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Regarding sustainable investing in particular, there’s a lot of ESG (environmental, social and governance) data out there. The advantage with index funds is volume. When you use data across a large universe of stocks, on average you move the portfolio in the direction you want in terms of your ESG requirements.
There’s a lot of choice, as well, among index providers, and the ability to customize: you could say ESG indexes have different shades of green. For example, light green will be close to market cap indexes. They will just tilt away from stocks with lower ESG ratings and overweight those that have sustainable practices. Dark green might screen out 75% of stocks. The darkest green would have only the best-in-class stocks.
The biggest asset managers have their own ESG scores. They use multiple sources of ESG data and supplement that with their own proprietary data. We’re seeing a lot of demand for this.
How would investors make this passive ESG move?
Not all investors would want to make the move to ESG-focused funds, as all investors have different objectives. But some investors want to move the bulk of their assets, which tend to be in traditional index funds, into ESG investments. Investors have often put part of their money in sustainable actively managed funds, but some increasingly want to make their overall portfolios aligned with ESG. To do that, they can move their traditional index fund investments into sustainable index funds.
What about risk and return?
We are seeing evidence that ESG assets performed better and at lower risk than the broader market—particularly over the past year, when they outperformed traditional assets by 1%-2% in a very challenging landscape2.
Going back to the idea of shades of green, the darkest green is the “purest,” you could say, in terms of ESG. But the darker green you go, the more risk in your portfolio, because fewer companies qualify and the universe of stocks is less diversified. Most experts agree that diversification is key to minimizing risk in a portfolio3. If you go lighter green, you would have more companies and you would get closer to market return. But under Covid-19, darker green did better than lighter green. Quality mattered more than diversification.
Can passive sustainable investments be tailored to investor priorities?
Yes—asset managers are well placed to work with investors to construct personalized portfolios.
In the wholesale and retail space, there are more ETFs offering choices. Individuals are also building bespoke portfolios. On the institutional side, we see far more granular choices. Some institutional investors go for basic exclusion—fossil fuels, tobacco. Then they might have a particular factor they want to emphasize, like water conservation or human capital. Within that, they might have different risk/return objectives. The biggest, most sophisticated asset owners—institutional investors—have moved toward an individualized approach.
One size doesn’t fit all. Investors don’t want to compromise.