Active fund managers may find it hard to defend their mainly higher fees compared with their passive fund peers, but when it comes to sustainable investment they often claim the moral high ground.
This is because they can choose to divest from, or sell shares in, any offending company, depriving it of capital and thereby, in theory, influencing management decisions. Passively managed strategies, in contrast, follow an index and, instead of selling, their only recourse is to talk to, or engage with, the company.
The investment community has been split over which is the most effective approach but, globally, 1,600 institutions have made public commitments to divest from fossil fuels, according to UK Divest, a pressure group.
The question remains whether such actions are likely to achieve their desired effect.
An academic paper published earlier this year looking at S&P 500 companies from 2005 to 2021 suggests not. The authors found that, when investors reduce their stake in companies with high climate exposures and carbon emissions, “firms take no action to change their future environmental profile, even though they are confronted with a higher cost of equity”.
The academics reported they observed concerted action by companies to reduce climate change exposures and carbon emission intensities “only over periods of increased media attention to climate change”.
The findings provide support to passive investment managers, who must rely on engagement only.
Supporters of engagement over divestment can also be buoyed by research published last year on Japan, where concerns had risen because institutions had come to own more than half of locally-listed companies by 2010, compared with only a fifth around 10 years earlier.
The authors concluded that “if multiple investors attempt to engage with the same firm, the accumulated pressure from investors pushes the manager to resolve the issue”.
“There seems to be a consensus among industry participants and academics that the most effective approach to produce a change in company behaviour is direct engagement,” says Hortense Bioy, head of sustainable investing research at Morningstar.
Engagement rather than pure divestment might also suit the new global status quo, where investing according to desired environmental, social and governance outcomes has run into political storms. In the US many states have passed legislation arguing that pension funds should focus only on financial returns rather than long-term sustainable outcomes.
It could be easier to avoid external criticism or censure if an asset manager or institution is talking to a company, rather than selling its shares.
Even supporters of sustainable investing have been vocal in their criticism of so-called greenwashing, which is when organisations try to pretend they are more sustainable than they are.
The demand for tighter rules has forced global regulators to introduce new regulations to control the labelling and marketing of sustainable strategies, many of which, investors had complained, contained the very companies they had hoped to avoid.
One response to the furore on both sides of the political spectrum has been “green-hushing”, in which companies and the institutions that invest in them pursue sustainable objectives, but do not publicise this. Again, engagement, which tends to be less publicly visible than divestment, would lend itself to the new status quo.
Sustainable fund investors may not have considered whether divestment or engagement is the right approach, but they are mainly opting for cheaper passive approaches to investing, for which engagement is the only option.
The latest data on sustainable fund flows from Morningstar shows that passive funds are continuing to win the battle for new sustainable investment money. In Europe, the largest sustainable fund market, investors poured $9.8bn into passive funds in Q3 compared with just $508mn into their actively managed counterparts.
In the US, where the political debate has grabbed headlines, actively managed sustainable funds suffered outflows of $3.6bn, versus inflows of $1.3bn into passive counterparts.
The numbers are a far cry from the last quarter of 2021, when active European sustainable funds still dominated, attracting $81bn in new investor money, while their passive counterparts hoovered up $52bn, according to Morningstar.
With so many factors to balance against each other — costs of ownership, the wisdom of divestment versus engagement, and the political pitfalls of any kind of publicity surrounding sustainable investing — perhaps it is unsurprising that some asset managers are giving their investors a choice on engagement.
Vanguard last month became the latest large manager to allow retail investors to have a say on proxy votes.
The initiative will allow nearly 4mn people controlling up to $250bn in shares in US companies to choose between five options, including letting Vanguard make the decision or specifically choosing to prioritise ESG factors.
The decision comes after Vanguard’s big index fund rivals, BlackRock and State Street Global Advisors, introduced their own schemes.
The fact that nearly half of Vanguard investors who have expressed a preference have told the asset manager they are happy to go along with Vanguard’s own choice reveals a further complication in the debate over active versus passive management — that frequently passive fund managers are making active choices, even if it is to do nothing.
However, the experiment being conducted by BlackRock, State Street Global Advisors and Vanguard is in effect offering retail investors the kind of engagement influence that large institutional fund managers enjoy today.
Amin Rajan, chief executive of Create Research, a consultancy that works closely with pension funds, says sustainability outcome metrics are explicitly hard-wired into investment mandates. “This group mainly involves large pension plans and endowments,” he says. “They are targeting companies that are willing to be transitioned from being sustainability laggards to sustainability leaders through active engagement so as to deliver market-beating returns.”
