When comparing different passive funds, investors focus on costs, tracking error and tracking difference.
We think they should add another consideration: ESG issues. This is something we do in our passive fund due diligence.
Power to influence
To achieve a return as close to the chosen benchmark as possible, passive funds must hold all (or the vast majority) of the stocks in the benchmark. They are, in effect, forced buyers with limited ability to divest, even if a company has poor business practices. This weakens any sway passive funds may have over investee companies - they can’t threaten to sell their holdings if a company fails to improve.
Passive funds typically hold hundreds of positions and have smaller investment teams compared to active managers. They focus on technology-based quantitative analysis, unlike the detailed company research active managers perform. This can make it relatively challenging for passive providers to build relationships with companies across the portfolio and engage with them on key ESG issues.
In reality however, passive funds do have influence. Passive products are hugely popular, so their providers hold a significant portion of shares and bonds. Take BlackRock, Vanguard and State Street for example. Collectively, they own 22% of the average company in the S&P 500 index (1) so their support is crucial in the approval process for a proposal. As the top 3 shareholders of Exxon, these three were central in supporting the activist investor Engine No 1 in ousting 3 of Exxon’s board members. Their grounds? The company had been too slow to agree a strategy to reduce its carbon emissions (2).
Passive providers have a responsibility to engage with investee companies on the most pressing ESG issues, as well as exercising voting rights thoughtfully in equity funds. This is for the good of their clients’ investments and to help encourage companies to improve for the benefit of the whole market.
What do we look for in passive funds?
We review the passive funds in our universe in detail twice a year (3). With our Ethical Oversight Committee, we’ve created an ESG questionnaire for passive providers and we formally incorporate the responses in our scoring of passive fund houses.
While we recognise that our passive solutions don’t have a specific ESG mandate, we expect leading passive managers to be performing well across the ESG-related areas listed below, in order to fulfil their fiduciary duty to clients, provide good transparency, and manage risks:
- Reporting – we review the firm’s voting policies and the content of its stewardship reports.
- Voting (equity funds) – we analyse how managers tend to vote on ESG issues.
- Affiliations – we look for professional affiliations like UN PRI signatory status to demonstrate their commitment to ESG.
- Leadership on ESG initiatives – we consider whether the firm is for example, setting a net zero emissions target and the processes in place to achieve it.
A moving target
Parmenion is now a UN PRI signatory and we incorporate ESG considerations to a degree in fund due diligence across all of our core active and passive solutions. We’ve got a long history of ethical and sustainable investing having managed our dedicated Ethical Active solution for over 10 years.
We’ve also launched a new Passive ESG solution with a greater focus on ESG issues as an option for investors who want to incorporate some ethical screens into their passive portfolio.
The standard of how ESG issues are being integrated across the passive fund industry keeps improving and we’ll play our part in this by:
- Scrutinising providers’ ESG credentials every six months.
- Keeping our ESG questionnaire for passive funds, and the scoring of the responses, under review.
- Providing open and honest feedback to the providers of these solutions to highlight the areas where we think they’re doing well and where there’s room for improvement.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.
Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.