Another day, another chapter in the active v passive debate. Yes, that old cherry keeps rumbling on, but when it comes to environmental, social and governance criteria (ESG), and sustainability more broadly, it really is worth looking again at the value proposition.
Why does this matter? Because of the importance of the pricing signal – in other words, using the capital allocation process as a way of signalling to companies that those with more sustainable business practices will be rewarded with better share prices.
There are essentially two ways investors can influence companies to improve their business practices: stewardship and valuation.
Stewardship is the most direct mechanism. Portfolio Manager A talks to Company B, asks questions about how the company might improve their record, a constructive dialogue follows, and then Company B goes away and takes some positive steps to improve. Portfolio Manager A has subsequently influenced the company to improve its record on ESG issues. Reality is of course rarely this simplistic, but the key part of this process is the dialogue and direct interaction between the investor and the company.
The other way investors can influence companies to improve their business practices is through the pricing mechanism. If enough fund managers are using ESG criteria in their stock selection process, then we should see a feed-through effect in stock prices so that companies with better ESG scores start to outperform those with low scores.
This is a vital step in the mainstreaming of ESG and sustainability because, if this pricing signal is working, then the risks and opportunities associated with extra-financial factors would automatically be captured in the stock price. By extension, investments managed passively against traditional market-cap benchmarks would capture the same information. And, at that point, investors no longer have to make a conscious choice about whether to integrate ESG into their portfolios or not. It would already be built in.
So how do we get to that point?
According to consulting firm McKinsey & Company, more than a quarter of global assets under management are now being invested in a way that integrates ESG factors in recognition that they can materially impact a company’s performance and market value.
And, thanks to WPP, Facebook, The Weinstein Company, Bell Pottinger (remember them?), and the litany of other corporate scandals that continue to make headlines, the investment community is constantly reminded that environmental, social and governance factors can have a material, and sometimes devastating, impact on corporate sustainability.
Furthermore, if you look forward five years to get a view of where the regulatory framework is going, it’s clear that things are moving in one direction. Take the European Commission’s Action Plan for Financing Sustainable Development, for example. It is not just looking to move businesses towards more sustainable practices and models, but is putting increasing onus on investors to play their part in driving the change.
Within that context, two things should not be ignored: one, companies with unsustainable business models or poor business practices will find it increasingly difficult to continue to operate, which is bad news for investors; and, two, investors will find themselves the subject of increased regulatory attention for failing to build sustainability into their portfolio process. Again, not good news for investors. So the message really is: change or be changed.
So how does this play into the active v passive debate? Well, there is no scope within the pure passive sense for this transition to be captured except through the wider pricing signal.
PwC estimated that global passive assets were set to more than double from $14trn in 2016 to $37trn by 2025. If that’s the case, those $23trn dollars headed into passive strategies really need that pricing signal to be working. If prices are not fully reflecting sustainability and ESG criteria, then passive investors have no defence against value-destructive scandals or exogenous shocks along the road.
Perhaps active managers that embed these considerations are worth another look because they will be increasingly influential in determining which companies thrive, and which flounder. And that should give active managers with a proven ability to screen for sustainability factors a valuable edge when it comes to both risk mitigation and return generation.
Most read articles
A quick cuppa with Faith Ward, Chief Responsible Investment and Risk Officer, Environment Agency Pension Fund