Index managers are using their size and heft to influence corporate behaviour
• The rise of passive management is coinciding with increasing investor interest in responsible investment
• Passive managers are using their size and long-term investment horizons to drive responsible corporate behaviour
• More responsible investment indices exist but questions remain over methodology and consistency
Two unrelated but coincidental investment trends are happening across Europe. The first is a switch from active to passive investing. The second is an increasing interest in the investment risks posed by climate change.
According to the Mercer European Asset Allocation survey 2018, more than half (52%) of portfolios are run under passive strategies; an increase of 1% from last year. At the same time, the number of investors considering the risk of climate change increased from 5% to 17% over the past year.
The main motivation for choosing passive over active is clear – cost. Investors have limited resources to spend on management fees. It makes sense to switch to low-cost index management for vanilla equity and bond strategies and put active managers to use on more complex alternatives.
Meanwhile, the sudden increase in interest in climate change is promoted by what Mercer calls regulatory ‘nudges’. For example, the UK’s Pension Regulator and the European Commission are asking investors to give statements on their environmental social and governance (ESG) investment strategy.
The two trends may be coincidental, but they are interlinked. If investors are interested in ESG investing while switching to passive strategies, it stands to reason that they will expect their index managers to offer suitable, responsible products and approaches.
The 2017 Willis Towers Watson asset manager survey found client interest in sustainable investing, including voting, increased across 78% of firms (see table).
It is no surprise then that some of the biggest names in index management are itching to show their ESG credentials. BlackRock chairman Larry Fink used his annual letter to the CEO to make clear the commitment to ESG issues.
He said the world’s largest asset manager would engage in “year-round conversations” to improve long-term value for investors. Claiming engagement would be taken to a “new level”, Fink said BlackRock vice chairman and co-founder Barbara Novick had been charged with leading global investment stewardship.
The challenge for passive managers desperate to prove their worth in the responsible investment space is that they are wedded to an index. If they are paid to track the FTSE 100, that is exactly what they must do.
But passive managers argue that driving positive corporate behaviour is no longer about divestment. It is about long-term engagement with companies in which you have millions of dollars invested; the very definition of an index manager.
Meryam Omi, head of sustainability at Legal & General Investment Management (LGIM), says: “We are investing in these companies for the long term. We can set expectations and we will still be there checking on how they are behaving in a year or two or three years’ time. We work closely with company boards, we have a seat at the table and we can shape what happens.”
Similarly Sarah Gibb-Cohen, head of equities product management for Europe at Vanguard, says her company might offer passive management but it is not a passive investor. “We are holding these companies for a very long time and that is a strength. We are passive investors. We are not passive owners.”
She adds that Vanguard attended 900 company meetings and cast 170,000 proxy votes last year. And this year the asset manager set up an active stewardship team in Europe to work alongside an established counterpart in the US.
LGIM took the ESG fight even further in June by naming and shaming companies that were failing to meet its climate change standards.
Mette Charles, senior investment research consultant at Aon Hewitt, says naming and shaming has been impactful in driving positive corporate behaviour. “Legal & General have been one of the most vocal in naming and shaming [ESG] leaders and laggards. Where companies are shamed or excluded from an index, managers get a call immediately to ask what they need to do to get back in.”
State Street Global Advisors (SSGA) is also seeking to drive change in terms of gender diversity. In 2017, the asset manager launched its ‘Fearless Girl’ campaign targeting diversity on company boards.
Since then, more than 300 companies identified by SSGA have added a female director and a further 28 have committed to do so. This resulted in a decrease in the percentage of companies in the Russell 3000 index without a female director from 24% at the end of 2016 to 16% by June 2018.
During the 2017 proxy season, SSGA voted against 512 companies for failing to act on gender diversity, and in the first half of 2018, through several country proxy voting seasons, voted against 581 companies. SSGA says it has also expanded its engagement programme with initiatives in Japan, Canada and Europe.
Ana Harris, head of equity portfolio strategists at SSGA, says: “Engagement is as important as voting. We have always engaged but over the last few years we have been more vocal. We are raising the bar.”
Yet even with the many trillions of dollars in assets under management and their increasingly large market share, passive managers can only go so far in reflecting ESG views when investing in market cap indices. The response has been to build more specialist ESG-focused indexes.
LGIM has been particularly busy in index construction, building a range of new indices that incorporate ESG principles. Its Future World Fund range covers corporate bonds and equities from companies with a ‘greener’ ethos. The latest addition to the range is the L&G Future World Gender in Leadership UK index fund (GIRL), which allocates more to companies that have achieved higher levels of gender diversity. LGIM measures diversity using its own methodology.
However, Aon’s Charles says the range of ESG indices from different providers can lack consistency because of variations in methodology, subjectivity and a lack of data. This can make it difficult to understand just how well – or badly – a company is performing.
Unlike a traditional market cap index where constituents feature based on their size, the principles on which companies appear in an ESG index can be less clear-cut. Charles says: “The problem you have with ESG indices is data providers have their own methodologies which means correlation across [ESG indices] is very low.”
Effectively then, not all ESG indices are made equal and investors need to be sure they understand what their manager is investing in and why and be sure it is aligned with their own views on what is important.
Accessing an index that tracks exactly the ESG issues of concern to investors may not always be possible. But passive managers are keen not to overdo it in this area. LGIM’s Omi for example says she will not ‘throw the kitchen sink’ at index creation.
There is still plenty of choice out there and new indices are launched with regularity. In September, MSCI released a suite of ex-tobacco involvement indexes covering five regions.
The focus for passive managers remains on building their ESG propositions. Most managers split their priorities for the coming year into investment and stewardship.
BlackRock says it will integrate ESG across all its investment teams to ensure that each team has ESG policies “in line with their fund’s objectives”. It will also release new ESG products and continue to evolve its sustainable investing research efforts.
Stewardship priorities for the rest of the year and beyond include board composition, effectiveness, diversity, and accountability. The manager will also target compensation policies, company culture and climate risk disclosure.
Vanguard’s stewardship focus is on “increasing [its] voice at the table” of European companies, utilising the new regional team. Gibb-Cohen says Vanguard will tailor products to suit the differences across regions and countries. “We want [products] to be scalable so they are low cost, but also meet investors’ different needs,” she says.
Passive managers have a colossal influence over the world’s biggest companies. As active owners they can drive real positive change making a difference to the wider environment and their clients’ portfolios.
They must maintain this momentum and ensure future initiatives are taken seriously by investors and companies alike.