The Principles for Responsible Investment (PRI) has launched a consultation into two challenges it believes the growth of environmental, social and governance (ESG) in passive investing faces; ESG incorporation and active ownership.
The discussion paper, entitled How can a passive investor be a responsible investor?, looks at the impact passive investing is having on ESG factors and the potential risks involved.
The growth of passives has been well documented. By the end of April, passive US equity funds drew level with their active counterparts after hitting $4.3trn assets, according to data from Morningstar.
Due to this rapid growth, the PRI has identified two areas where it says passive investing could cause issues; the way asset owners incorporate ESG factors and active ownership.
ESG incorporation includes issues such as the availability and consistency of corporate data, consistency of ESG scores, complexity and transparency of indices, unintended portfolio skews and costs.
While for active ownership, the paper has looked into areas around free-riding, familiarity with holdings, resourcing, contribution to overall portfolio performance, divestment, proxy voting regulations, stock lending and acting in concert.
For example, the report explains because passives track an index, divestment is largely not an option for investors if engagement fails or standards fall below a certain level.
Furthermore, investors in passives have very little incentive to undertake ESG engagement because the small size of each individual holding means minimal impact and the costs of engaging with a diverse portfolio may be prohibitive.
Toby Belsom, director, investment practices at the PRI and co-author of the report, adds: “Under these circumstances, passive investors may prefer to ‘free-ride’ on the efforts of other investment managers and asset owners.”
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Stock lending is another issue for active engagement as voter rights are passed to the borrower of the assets.
“Due to low annual fees, income from stock lending tends to represent a larger proportion of their overall income on passive funds when compared with active funds,” Belsom explains.
“The potential implication of this is that passive managers may be incentivised not to recall stock to vote at AGMs.”
The PRI is looking to gather feedback from industry participants until 31 October.
