LGPS: Passive or responsible? You can’t have it both ways.

William Bourne argues there is an “irreconcilable conflict” between, on one hand, the increasing popularity of passive funds and, on the other, sustainable investment.

Over the last 20 years the trend for investors to invest passively has gathered pace. The drivers have been lower fees and “better” performance. I put “better” in quotation marks because, while passive has certainly captured the outperformance of mega tech stocks far better than many active managers, it has been at the cost of much greater concentration, which implies higher risk. Be that as it may, for a swathe of investors passive is now the default choice.

The other major trend over the past 10 years has been responsible or sustainable investment. Pension funds are now obliged under the Stewardship Code to act as responsible investors and when investing to take into consideration ESG (environmental, social and governance) risks, most notably, of course, long-term climate change. In practice, most see that investing sustainably is well aligned with their own fiduciary duty.

I argue in this article that there is an irreconcilable conflict between these two trends, and investors are ultimately going to have to choose between either cheap passive or more expensive responsible investment. In my view that means they will have to give up the cost benefits of passive for a higher element of active management.

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Market weighting

I advance three arguments why passive investment cannot be responsible. Let me start with the case of traditional passive investment based on a market cap weighted index, typically costing a few bps nowadays.

By definition this results in a portfolio invested in all companies, both responsible and less so. In the case of fossil fuels, for example, the investor will be exposed to the full market weighting without any scope to reduce it. If it turns out that the value of oil reserves is overstated, then an investor in a passive fund will bear their share of the financial detriment.

Smart beta solutions, such as carbon-tilting indices, have evolved over the past 10 years to mitigate this problem but are often not much better. They target the same index performance while promising lower carbon emissions. Unless they are adding alpha in other ways, they will therefore not mitigate the financial risk.

Nor do they always offer a better outcome in terms of total carbon emissions. They may “tilt” away from the worst sinners, but frequently they replace them with stocks which may score better on their metrics but, in the real world, either directly or indirectly contribute to greenhouse gas emissions just as much. A classic example is excluding oil companies but overweighting oil services or pipelines.

The ESG data on which they base their scoring is also far from robust. Unlike financial metrics, the data is, in most cases, not audited or standardised. An academic survey* found that the correlation between ESG pairwise ratings calculated by five leading data scorers was, on average, around 0.6.

By way of comparison, that of credit ratings was found to be 0.99. Let me be clear, I am not criticising the ratings agencies and I do believe this data has some utility.

The problem lies with the users and particularly where, as with smart beta, the data is used mechanically to allocate money across what may comprise a large part of an investor’s equity portfolio.

The Japanese Government Pension Investment Fund (GPIF) similarly measured ESG score correlations between FTSE and MSCI over three years to March 2019 and found a correlation in the order of 0.2 across both Japanese and non-Japanese companies. Worryingly, there was little sign of improvement between 2017 and 2019.

Engagement

My second argument against passive is the difficulty of acting as a truly engaged shareholder across a range of up to 3,000 stocks (depending on the index) all over the world.

True engagement involves understanding the reasons behind a company’s behaviour, assessing its long-term sustainability and, if needed, agreeing a common angle with other investors to persuade it to change its ways.

Not only does that take time, but an active analyst’s input and knowledge can add substantial value that is not accessible to a passive manager’s ESG team.
A major active investor I spoke to recently claimed to have a team of up to 20 staff engaging with perhaps 400 stocks within their entire target investment universe. I find it hard to believe that passive managers can engage at anything like this level. They may well tick the Stewardship Code box by voting at AGMs but lack of resources means it is hard for them to engage in any real depth except for a few high-profile cases.

Incumbent companies

My final problem with passive is the bias to incumbent companies. By definition the index contains companies which have reached a certain size and does not include emerging companies with bright ideas for a more sustainable future. As evidence for this, take the case of a search exercise I was recently privy to for a manager with this kind of strategy.

The three short-listed managers all had active shares of over 0.90, ie. less than 10% of their portfolio allocations overlapped with the mainstream index. That illustrates how far away passive investment is from a portfolio really targeted at solving the planet’s sustainability problems.

I therefore conclude that, over the next few years, investors will have to weigh up the higher costs of active management against the desirability of investing sustainably. They should not delude themselves that it is possible to have it both ways.

William Bourne is principal of Linchpin Advisory Limited and has roles with five LGPS funds.

* Berg, F., Kölbel, J.F. and Rigobon, R., 2019. Aggregate confusion: The divergence of ESG ratings. MIT Sloan Research Paper No. 5822-19.

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