When it comes to environmental, social and governance (ESG) investing, there’s a lot for clients and advisers to think about.

    Should certain companies be excluded due to poor ESG credentials? Or is engagement the key to driving positive outcomes?

    Is the environment the key focus, or workers’ rights? Are returns the main aim for clients, or do they play second fiddle to ESG outcomes?

    These are just some of the key questions when it comes to defining what clients may want from ESG investing.

    But there’s another area that keeps cropping up - the role of active management.

    Increasingly vocal arguments are being made (primarily by active managers themselves) about how active investing is ideally placed when it comes to ESG investing. The qualitative aspect of active investing - allowing managers to pick and choose companies on ESG criteria - is generally the focus.

    Certainly, active funds can use their freedom to go ‘off benchmark’ to invest in stocks they define as better proponents of ESG standards.

    But to believe this is the only way to approach ESG is to overlook an increasingly dynamic passive industry, and one which is constantly developing new and improved options.

    Take Legal & General’s Future World Fund range – a series of multi-factor global equities index funds with a climate tilt. It limits exposure to carbon-intensive businesses, and gives higher weightings to companies that contribute positively to a low-carbon environment.

    The range tracks specific ESG-friendly indices, such as the FTSE All-World excluding Controversial Weapons Climate Balanced Factor Index. It targets better long-term risk-adjusted equity returns than a traditional index strategy, while limiting exposure to companies poorly positioned for a transition to a lower carbon economy.

    It’s by no means perfect. Measuring a company’s exposure to climate change risk is something the industry is still getting to grips with.

    However, it offers a realistic passive alternative for clients who want to prioritise ESG but keep costs down.

    The passive voice

    Critics will argue that although these funds may be investing in ‘greener’ names than other indices, being passive means they won’t be able to make headway in the boardrooms of companies they invest in.

    But arguably that shows a lack of understanding of how the passive industry is changing. For one, thanks to regulation, there is no chance of passive funds failing to meet their responsibilities.

    Stewardship codes, such as the one in the UK, are putting much greater obligation on all managers, including passive funds, to ensure they are acting as agents of positive change.

    The other factor to consider alongside regulation is the evolving nature of passive funds. These are not static indices – the positions they take today will change over time, either via shifts in markets or indices, or through rebalancing and amendments to the investment approach.

    The notion that only active funds have a regular dialogue with the companies in which they invest is simply not true. Clearly, asset managers with index funds (often alongside active ones) are communicating with companies like BP on a whole range of issues, including environmental ones.

    Indeed, some of these companies are so successful in their approach to ESG that they are winning awards for it. L&G was one of the top five global asset managers found to have a clear and detailed strategy on the climate, based on a review of the 30 largest asset managers globally by London-based think-tank InfluenceMap. It also received an A-rating from ShareAction for its ESG performance last year.

    While divestment remains an option that few passive funds ultimately turn to, there is scant evidence to suggest that shunning these stocks actually brings about change.

    Exclusionary portfolios have been around for more than two decades, shunning tobacco, weapons, alcohol and other areas. Companies impacted by this have not ceased to exist as a result – far from it in many cases.

    Passive funds then, can deliver the positive change over the long-term that clients are increasingly looking for. There are different ways to go about it – and everyone will have a different take on what ESG means for them – but the industry is well versed in creating increasingly specific strategies to cater for all needs. It will be no different when it comes to ESG.

    Jonathan Letham
    Head of IMX

    Past performance is not a reliable guide to future performance. The value of an investment can go down as well as up, and may be less than the amount(s) paid in.