Is ESG the future of active management?

ESG is providing a way forward for the active management industry

It is no secret that the active management industry has been on the backfoot.

In terms of performance, many fund managers struggle to consistently beat the market.

The 2020 year end Spiva scorecard, published by S&P Dow Jones Indices, found that fewer than one in 10 sterling-denominated US equity funds outperformed the S&P 500 in the decade to the end of last year.

While the US market is notoriously difficult to beat, the results are not especially encouraging elsewhere. Most global, emerging market and European funds also struggled.

In the case of the best performing group, UK small cap equity, less than 40 per cent of funds outperformed.

As the chart below shows, the results have looked more encouraging in the shorter term, especially when it comes to UK and European equity portfolios.

But whether because of performance issues, a growing awareness of cost or other reasons, investors have steadily migrated to passive funds in the past decade.

Investment Association figures show that trackers made up 18 per cent of the assets held in open-ended funds by UK investors at the end of January this year – a huge leap from their 6.9 per cent market share at the end of 2011.

These figures do not even account for the significant volumes of money in exchange-traded funds.

While uncertain times are often seen as a chance for stock-pickers to shine, we are yet to see that the pandemic has done anything to halt the shift to passive.

Suggestions of passives' market share having 'peaked' in 2020 are also yet to prove obviously correct. Calastone, another organisation tracking fund flows, noted that when traditional active equity funds suffered heavy outflows in January this year, index funds continued to pull in money. “Despite the sharp reversal of investor sentiment, [index funds] enjoyed inflows of £485m in January,” the business noted. This was in line with the monthly average of recent years, if lower than in some previous months.

But a more promising future may be emerging for the active management industry. While passives might continue to either snatch market share or at least maintain their presence, another source of growth appears better suited to active.

The same Calastone data, covering January’s fund flows, points to this. While the research paints a picture of passive funds prospering over 'traditional' active products, active ESG funds soaked up investor assets.

ESG equity funds enjoyed their third best monthly inflows in January according to Calastone, marking the continuation of a trend that appeared to finally take on momentum last year.

In one form or other, ESG looks to define the future shape of the industry. But this will pose its own risks and challenges.

Equally, there is no guarantee that active ESG will escape the passive threat. Importantly, any form of ESG exposure will require a significant level of knowledge and due diligence from intermediaries.

ESG: an active manager’s game

Andrew Bailey pointed to both these developments a few years ago. In a 2018 talk to the Investment Association’s Culture Conference, the then FCA boss suggested that the rise of passive and ESG, respectively, would be two defining trends for the investment industry.

Yet, he hinted that ESG would be better suited to an active format.

“A longer-term shift towards passive investing goes alongside a desire for more ethical and socially responsible investing and a desire to encourage longer-term patient capital,” he said.

“Of course, these two developments can co-exist. Indeed, I would go so far as to say that they will, and that in doing so there will be some re-clarification of the meaning of active management.” He added that passive could co-exist with “a world where investors also want to express a preference which embodies their values and longer-term goals, with ethical objectives, for instance”.

The idea of active as a natural home for ESG makes sense, given the need to carefully choose suitable investments. Active can also cater to the subjective nature of definitions such as 'ethical', to an extent.

Well-known ESG fund managers, including those on the WHEB Sustainability fund and Liontrust’s Sustainable Future range, will often tend to break their portfolios down by different investment themes.

Investors can, to some degree, assess these and decide whether a fund’s approach is in line with their beliefs.

Investors also have a choice of more targeted funds if they wish. Morningstar data found that while 372 'broad ESG' funds launched in Europe last year, 64 environmental funds also arrived. Some 25 social impact funds launched, with 24 new funds focused on other themes.

Some investors, of course, will have idiosyncratic views on what is ethical, sustainable, or in keeping with other criteria of importance to them. They may be best suited to an individual approach, such as a bespoke portfolio run by a wealth manager.

Inevitable complications

With asset managers flocking to enter the ESG space, several complications have emerged, both for product providers and their customers.

Firstly, there is the question of what is authentically ESG, an issue that challenges many parts of the investment industry. Companies, or other organisations, may attempt to brand themselves as ethically or environmentally minded in a bid to attract equity or bond investors.

Funds may therefore end up investing with companies or other organisations that actually fall short on the ESG front. Controversially, ethical funds run by the likes of Aberdeen Standard Investments and Premier Miton Investment were found to have positions in Boohoo when the fast-fashion name was hit by allegations relating to working practices in mid-2020.

Even investments widely held by ESG funds with good reason can run into trouble: Kingspan, an insulation specialist previously held by various ESG managers, has become ensnared in the Grenfell Tower fire scandal, for example.

Other holdings will prove highly divisive: the green credentials of Tesla, a big holding for Baillie Gifford’s Positive Change fund, came into question earlier this year when the company invested in bitcoin. The cryptocurrency is controversial in part for how much energy it consumes.

Likewise, some funds may have taken on ESG as a marketing label without implementing the correct processes. Morningstar’s assessment of 2020’s ESG trends found that of the 253 funds that “repurposed” as sustainable in Europe last year, some 87 per cent had simply done so by rebranding their portfolio. Investors may therefore wish to be careful about fund providers that have only recently taken an interest in ESG.

What does ESG even entail?

What’s more, interpretations of ESG are evolving. Some funds will avoid 'bad' stocks or bonds in controversial areas, from oil and gas to tobacco and weapons. Others, such as WHEB Sustainability, will only back companies that are making a direct positive contribution to the cause they favour.

And yet another form of ESG, in which fund managers hold 'bad' companies but engage with them to advocate change, is gaining prominence. This could be especially important in regions such as the emerging markets, where stopgap solutions may be required. Renewables may not immediately be in place to enable a straightforward shift from 'dirty' to 'clean' energy sources in this part of the world, for example.

It is therefore worth noting a manager’s approach and how that fits in with different philosophies. Funds without an explicit ESG remit can also fit into the picture: even value funds, which often focus on industries such as oil and gas, may end up backing 'bad' names which stand to benefit from an increased focus on sustainability.

Some managers will even defend certain holdings as having a greater ESG case than many assume.

Terry Smith used an interview with FTAdviser sister publication Investors’ Chronicle last year to argue that tobacco name Philip Morris had some merit on the ESG front because of its work to move smokers away from tobacco and towards alternative products.

Funds should not necessarily be dismissed for lacking an ESG label, as they may still follow some of the relevant processes anyway. The SDL UK Buffettology fund, a strong performer within its peer group, does use some ESG criteria when assessing potential holdings, though this tends not to be prominently discussed. That said, fund managers without an explicit ESG remit may feel less obliged to consistently focus on these metrics.

Passive push

Active funds in the ESG universe still face competition from passives. ESG trackers of different stripes have proliferated in the past year and have proved highly popular.

Morningstar notes that passive funds have seen their share of the European sustainable fund market increase “considerably”, from 10.3 per cent at the end of 2015 to 22.5 per cent five years later.

These passives come in various forms, from ESG versions of conventional market indices such as the S&P 500, to certain thematic funds. Notably, the iShares Global Clean Energy UCITS ETF took in billions last year, while also delivering phenomenal returns. It has made a 110 per cent sterling total return in the year to April 22 2021, notably outpacing conventional equity markets.

And yet problems also exist for ESG passives.

There are many 'light' ESG versions of existing indices that actually differ little from the parent market. Even stricter indices, such as MSCI’s SRI ranges, can have exposures that may not obviously fit the ESG theme. The MSCI UK IMI Low Carbon SRI Leaders Select index, for example, has a decent level of exposure to mining major Rio Tinto. The thematic funds can have their own issues, from having big stakes in small and mid-cap stocks, potentially causing liquidity issues, to having positions in more liquid names that seem only tangentially related to the theme.

Passives may, therefore, have their own problems in meeting an ESG investor’s criteria. The concept is likely to provide complications for both the active and passive industry, rather than just asset growth.

david.baxter@ft.com