The ongoing switch within pension fund investing from active management passive index based investment is nothing new, but if anything this trend appears to be accelerating.
The merits passive investing have been well articulated; costs can be reduced and trustees can gain comfort around minimising investment risks, at least in actuarial terms.
The trend seems to be a continuing with many trustees adopting passive funds based incorporating socially responsible investment (SRI) criteria in their design. Certainly it is easy to see how this becomes even more necessary with a scheme membership that increasingly asks questions around the values associated with the investments made on their behalf.
This is an event to be celebrated since the allocation to capital to companies that are more responsibly managed is surely positive for society at large.
In September 2018, Citywire reported a 60% increase over one year in assets invested in European registered SRI exchange traded funds, then totalling £4.7 billion.
It marks the maturing of socially responsible investing in its various forms, as an inexorable and increasingly mainstream movement and no longer a niche activity of those investors who could afford to put their principles ahead of profits.
But there are reasons to take stock before we all swallow the arguments in favour of passive SRI strategies without considering the consequences.
Inevitably we need to think through how these strategies are designed; a potential investible universe of companies is considered for a range of quantified financial and societal factors. Amongst these are various metrics looking at the relative environmental, social and governance (ESG) positioning demonstrated by each company: in this way the portfolio manager might not only exclude those companies that are involved in potentially controversial activities, such as the manufacturing of tobacco or armaments, but also prefer those that, say, produce less carbon dioxide per dollar of revenue turnover, or which have achieved a better gender balance amongst their company directors.
The manager then builds their portfolio of their preferred companies investments and reports the ranking of E-S-G scores for their aggregate portfolio for comparison against the unconstrained benchmark index. The latter naturally includes all the worst corporate practices and ESG scores for all companies listed within that index, thus the comparison should be favourable.
All good so far. Except that to build a passive SRI portfolio the manager is having to balance out a variety of factors in order to produce an investment that they believe will continue to offer the desired risk and return profile. This likely includes conventional measures such as share price momentum or company balance sheet size since the objective is to achieve or enhance the actuarial characteristics of the unconstrained reference index. In so doing, the manager is often deciding to compromise on some of the ESG criteria of individual companies selected.
So for example, while the total portfolio may display an environmental score stronger than the reference index, so they may have selected and given added weighting to companies with an unsatisfactory governance standing, say around whistle-blowing policies. Or perhaps, in order to achieve a low overall portfolio score for carbon generation so they may have allowed a greater weighting to companies with a poor record of labour relations within their supply chain.
Or maybe the manager favours companies that present nominally progressive corporate policies across a range of governance issues, while having a dismal track record of implementation.
Within the trade this is known as “green washing”, which involves the promotion of one set of societal credentials to obscure poorer corporate practices elsewhere.
The point is not to be critical of this process of factor compromise per se, rather to alert the investor that aggregate portfolio ESG scores can themselves be disingenuous or even misleading around underlying corporate behaviours of underlying investments.
Socially responsible investing is of course a financial marketers dream which allows generic labels such as ‘ethical’, ‘responsible’ and ‘sustainable’ to be readily applied without much discipline. And it is equally all too easy for trustees to tick the SRI box without thinking too hard about it.
Some firms will design strategies that expressly intend to favour one part of the sustainability spectrum over another; it is understandable that investors primarily seeking to address issues around climate change may not put the same priority on corporate governance structures. In such cases it is hoped the marketing literature and sales activities adequately identify what the fund does, and does not, set out to achieve.
To encourage better stewardship trustees should therefore require their managers to declare those exposures that individually demonstrate poor corporate practice in any area and to justify their ongoing inclusion. By extension trustees can insist that minimum standards are set for all companies within their portfolio across a range of measures beyond the headline portfolio ranking.
Without this fiduciary inspection it is fund managers who will define what is responsible investment, and capital may still be allocated to those companies that fall foul of investor expectations.
Trustees have an envious task since they bare ultimately responsibility for such decisions.
No doubt they do well to remember that in the world of Big Data such information is likely already in the public domain.
The ongoing switch within pension fund investing from active management passive index based investment is nothing new, but if anything this trend appears to be accelerating.