Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Search the internet for “passive sustainable funds” and you get a whole string of warnings. These funds don’t engage with companies, they rely on third-party rating agencies’ opinions, and can’t divest if they’re not happy.
Further investigation reveals that most of these warnings come from active fund managers.
Amid the growing body of research suggesting that you’d be better off just buying the index, sustainable investment has been one of the few areas where active managers have tried to make their case. Yet it relies on active managers living up to their promises on voting, dumping bad companies and actively selecting stocks. Their case is not currently convincing.
Passive sustainable funds are certainly growing in popularity. An investment adviser recently remarked that he would not have advised a sustainable investor to go passive just three years ago. Now, he said, he would take a closer look as funds are cheaper and offer a more sophisticated range of options.
Figures from Morningstar show that passive sustainable funds cost less than they used to, with annual charges for UK-available options falling to just 0.15 per cent last year from 0.17 per cent in 2019. The cost gap with active funds has narrowed over that timeframe, from 1.14 per cent to 0.95 per cent last year.
ESG exchange traded funds have more than doubled their market share of overall ETFs in the past three years to 20 per cent at the end of 2023, from just 8.6 per cent in 2020, according to Morningstar. Flows into passive sustainable funds in Europe have outstripped active flows since the second quarter of 2022, with the last half of 2023 seeing outflows from active sustainable funds but inflows into passive sustainable funds.
“We’ve seen more product launches and product conversions in the passive space,” says Hortense Bioy, global head of sustainability research at Morningstar. “Passive is doing a killing.” The new options include thematic funds and those with carbon emission targets as well as those focusing on biodiversity — a long way from the old-fashioned tactic of simply excluding certain stocks.
That is not to say that passive funds don’t hold questionable companies. MSCI and S&P have put companies linked to the Myanmar junta in their ESG products, as my colleague Patrick Temple-West reports this week. But active funds have questionable holdings too. It’s not hard to find oil and gas companies in supposedly sustainable vehicles, and accusations of greenwashing directed at active managers are the main reason we see so much new regulation around sustainable investment products.
At this point, active managers will protest that they engage with companies and help them transition out of fossil fuels. That would be nice, if they were actually doing that. A report last year from Majority Action, a non-profit, found that most companies that failed to meet investor expectations for a net zero ambition had no votes flagged against directors or for shareholder proposals on the issue by key Climate Action 100+ investors — who are supposed to be ensuring that polluting companies take action.
What’s more, passive funds aren’t as powerless as their name might suggest. Emma Wall, head of investment analysis at Hargreaves Lansdown, says Hargreaves rates LGIM’s Future World series of index-tracking funds highly due to their high levels of engagement with the companies they own.
Jeannette Andrews, senior global ESG manager at LGIM, says they put pressure on companies they hold, whether via passive or active funds, and that they can fine-tune their passive funds by making divestments. The Future World Fund, for example, currently excludes more than 70 companies from the index it tracks.
Bioy at Morningstar says that passive sustainable funds review methodologies much more frequently than other passive funds, partly because the data and research on climate risk and impact is constantly being developed.
“They can take out names if there is a controversy so they are more dynamic than any other passive fund,” she notes. MSCI recently introduced a “fast-exit” rule for some of its sustainable indices, which are used by BlackRock’s iShares products, following pressure from wealth managers to take quick action when companies have been embroiled in scandal.
Still, it’s not easy for the average retail investor to find out which passive or active funds are doing the best on stewardship, voting or divestment. This should be much more straightforward.
From a psychological perspective, there’s an argument that passive investing doesn’t come naturally. We want to believe that an active fund manager is clever and able to make decisions with our money that will add value.
If we’re investing sustainably, that psychological bias is even stronger, as it often reflects an initial wariness of the fund management industry: the desire to pursue returns regardless of how they are achieved sits uncomfortably with sustainable investors. So it makes sense that they would want to turn to individual professionals who share their views: the personal connection feels stronger.
But this isn’t necessarily the case. Active sustainable managers may still not be engaging or divesting as much as we’d like; their funds are also a lot more expensive. The reality of sustainable investment in equities is that it’s not the most direct way to achieve change. Sustainable bonds, where managers have more power to withdraw funding from companies if they don’t improve, have a greater impact.
In an ideal world, active sustainable funds would be genuinely active: the managers would use their voting rights, they’d engage with all their companies and they’d have strict policies about shunning companies that they weren’t happy with. The reality is that too many “sustainable” funds are still just a labelling afterthought.
Regulation is set to change this. And, of course, some actively managed sustainable funds work hard to engage and divest. But you might find yourself paying a higher fee for a mediocre active sustainable fund when a superior passive fund is doing a better job.
Alice Ross is an FT contributor. Her book, “Investing to Save the Planet”, is published by Penguin Business. X: @aliceemross
