The question of how passive providers construct ESG indices has been gaining prominence over recent months as climate risk mitigation and other ESG issues take pole position on investors’ agendas.

And while ETF issuers have been ramping up their engagement efforts, some believe they are not doing enough to deliver strategies that are able to bring about real positive change.

The alternative option for passive issuers is divesting from companies that do not meet strict ESG criteria. However, divestment for passive indices is not a simple task, requiring the building of custom-made indices or frequent rebalancing in response to negative news.

Detlef Glow, head of Lipper EMEA research at Refinitiv, noted that one of the main critiques of ESG ETFs is that issuers tend to “review their constituents only a few times a year and cannot in most cases react directly to controversies or scandals”.

For many, this leaves engagement as the only viable option, but views differ on how effective this strategy is for passive providers.

To divest or not?

There are arguments in favour of both engagement and divestment strategies. Laith Khalaf, head of investment analysis at AJ Bell, said engagement is often seen as a more effective tool to improve corporate behaviour, “because it can come from significant owners of the businesses, whereas a fund which divests is by definition no longer a stakeholder”.

However, he added “some investors putting money into ESG funds are likely to expect divestment, particularly from pollutive industries, so you can see how a mismatch might arise between investor expectations and industry delivery”.

Stuart Forbes, co-founder of Rize ETF, is firmly in the divestment camp, noting that “‘engagement’ in its current format is achieving nowhere near enough quickly enough”.

Rize ETF divests from companies that do not meet its ESG criteria – such as for example those with exposure to forest risk through commodities such as soybean, palm oil and timber – if they refuse to engage in an independent review of this exposure.

“It is high time the asset management giants step up and demonstrate their true firepower through a more activist approach to engagement and, failing that, public rebuke and divestment. Otherwise, we are facing a case of too little, too late,” Forbes said.

Alternative approaches

However, the decision to divest is not black and white. As Hortense Bioy, global director of sustainability research at Morningstar, explained, exclusions introduce active risk and tracking error to ETF strategies, something passive providers usually seek to avoid.

“Instead of divesting, passive managers have launched new ESG-screened ETFs to meet the demand of investors looking to align their investments with their values,” she continued. “Investor demand for baseline screens applied to passive products seems to be growing.”

In addition, Glow said he expects providers of sustainability indices to begin implementing index rules that will allow for a more frequent review and rebalancing of index constituents, as well as employing policies that will allow them to react immediately if a constituent no longer meets the index’s inclusion criteria.

He predicted passive providers would increasingly integrate active ownership into their strategies: “I am sure that we will see new concepts from the promoters of passive products to institutionalise the execution of shareholder rights. This means ETFs and other passive products are not too passive to implement a sustainable investment strategy by themselves and will become even more active within the foreseeable future.”

Active ownership

Meanwhile, engagement is becoming a key element for ESG-focused products, whether active or passive. However, while active providers tend to practice engagement on a wider scale, Bioy said the approach taken by passive managers is more “thematic and systematic in nature compared with active managers”.

Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing & Smart Beta, argued that “passive investors can be active owners”.

“It is often argued that without the threat of divestment, engagement is ineffective,” he said. “We find that by remaining invested in companies, we can continue to have a greater impact through voting and engaging than we would by simply divesting.”

He added Amundi has been working with index providers to combine engagement and divestment by developing “innovative indices which encourage engagement and have a rules-based approach to divesting from companies if they do not meet requirements over time”.

One example of this is the EURO iSTOXX Ambition Climat PAB index, which Amundi co-developed for a client in 2020. This index has a number of exclusions, including tobacco products and securities which generate revenues above a certain threshold from coal, oil and gas exploration or processing activities.

One crucial recent development has been BlackRock’s decision to offer institutional investors the opportunity to vote directly with companies.

In a letter to clients, BlackRock said: “This capability…responds to a growing interest in investment stewardship from our clients. These options are designed to enable you to have a greater say in proxy voting.”

The move by BlackRock will give investors greater powers when it comes to holding companies to account, and in turn, tackles the engagement argument which is typically thrown at the passive management industry.

Leaders and laggards

However, the question remains whether passive managers’ engagement efforts are as extensive and effective as they need to be.

A June 2020 report from ShareAction, titled Point of No Returns: Part III – Climate Change, found that two of the largest passive providers in the world, BlackRock and Vanguard, received some of the lowest scores on their responsible investment governance efforts.

From a list of 75 of the world’s largest asset managers, Vanguard came in at sixty-ninth place with the lowest rating of E, while BlackRock is in the fifty-seventh spot with a D rating. Lyxor, another prominent passive provider, also performed poorly, coming in at fifty-fourth place with a D rating.

In contrast, however, Amundi came in fifteenth with a rating of BB while Legal & General Investment Management (LGIM) is one of just five asset managers receiving the top A rating, coming third overall.

Morningstar’s Bioy said: “LGIM has long made voting and engagement core components of its investment approach and continues to set best-practice standards in this area. The firm is fully transparent on its engagement practices and publishes a regular leaders and laggards list of portfolio companies.”

ETF investors sharpen focus on engagement issues

As ESG ETFs continue to develop, it remains to be seen which firms emerge as the winners in this competitive space. With investors asking increasingly tough questions, passive providers will have to work hard to develop products and indices that stand up to scrutiny.

Given the work that is already taking place behind the scenes, it seems likely that a hybrid approach which combines engagement and divestment will emerge over time.

This article first appeared in ESG Unlocked: Sustainable Revolution In Full Swing, an ETF Stream report. To access the full issue, click here.