Environmental, social and governance (ESG) investment trends have blurred the line between passive and active strategies, according to a new survey of global pension funds.
The study by UK-headquartered specialist research firm, Create, found “the choice between actives and passives is not black and white”.
“This much is clear from the rise of granularity in ESG investing,” the report says.
“As innovation is moving to ever-narrower indices, this ultimately results in active decision making that mimics active stock picking. This applies especially to those indices targeting a triple bottom line.”
The Create paper says while ESG concerns will likely accelerate the move away from vanilla, capitalisation-weighted passive funds, naïve divestment policies are falling out of favour.
“Instead of excluding ESG laggards from the ESG indices, the emphasis now is on minimal exclusion, with an overemphasis on ESG leaders and improvers,” the study says.
And investors are increasingly tolerant of the tracking error that comes the more bespoke index construction techniques compared to standard cap-weighted benchmarks.
“Currently, 54% are content with a tracking error of less than 1%, 31% are content with one between 1% and 2.9%, and 15% are content with an error of 3% and above,” the Create report says.
However, about 35 per cent of respondents said recent regulatory and policy shifts would encourage them to tolerate higher tracking error to capture perceived benefits of ESG-tilted passive funds: a further 52 per cent said they might consider such a shift in risk tolerance.
But active management remains the preferred method of gaining ESG exposure for pension funds captured by the study: 43 per cent of those surveyed had at least a fifth of their ESG assets actively managed compared to 28 per cent for the respective passive statistic.
Active management holds the ESG lead because of its first-mover advantage, the Create paper says, but the gap with indexers is closing.
“Progress in the passive space came later when their managers delivered a range of indices, backed by stewardship and active engagement with companies in their indices,” the study says. “They are catching up fast.”
Regardless, investors will likely look to both active and passive styles to pursue ESG goals with the former expected to suit alternative assets and the latter more attuned to liquid markets.
The survey of more than 150 global pension funds representing some €1.93 trillion of assets under management also suggests investors are becoming more hard-nosed about ESG claims, demanding better quality evidence of impact, more consistent research and a “value-for-money fee structure”.
Amin Rajan, Create founder, says while ESG investment has been stung of late by poor relative performance and a “political backlash” (especially in the US), the sector is supported by long-term structural tailwinds.
“In comparison, the raft of regulatory and policy measures – unprecedented in scale and scope – introduced since the 2020 Covid-19 pandemic have attracted much less media attention,” Rajan says in the report. “The measures have the potential to transform ESG investing and adoption, as investor ambition is finally being matched by policy action.”
The study, sponsored by the DWS-owned exchange-traded fund shop, Xtrackers, surveyed 156 pension funds in 13 jurisdictions as well as in-depth interviews with 30 senior executives.