More than half of institutional investors believe the majority of their ESG investments will be managed passively in the next five years
More than half of institutional investors believe the majority of their ESG investments will be managed passively in the next 5 years © AFP via Getty Images

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Exchange traded funds and other passive vehicles are set to usurp active managers as the dominant ethical investing approach, research suggests.

The shift would be a body blow to active investment houses hoping their potentially greater ability to engage with investee companies would allow them to hang on to assets being invested according to good environmental, social and governance principles.

At present pension funds, mutual funds and insurance companies with ESG exposure in their portfolios allocate just 21 per cent of this money to passive funds, according to a survey of 101 European institutional investors by Invesco, a fund manager.

However, 45 per cent of the respondents said they planned to increase the amount they invest in ESG ETFs in the next two years, while just 5 per cent said they planned to cut passive exposure.

As a result, more than half of the investors believe the majority of their ESG investments will be managed passively within the next five years.

At present, just $2tn-$3tn of the $32tn invested in “sustainable” strategies is done so passively, according to estimates by Amin Rajan, chief executive of Create Research, a consultancy, based in part on figures from the Global Sustainable Investment Alliance.

Column chart of Net flows to ESG ETFs in the Emea region ($bn) showing ESG flows have already surpassed last year

“For the growing number of investors looking for funds with ESG considerations, it is clear that ETFs are playing an increasingly central role in helping them gain exposure,” said Gary Buxton, head of Emea ETFs and indexed strategies at Invesco.

He said that while investors were first attracted to ETFs due to their low costs and simplicity, “as we have seen so far this year, ESG ETFs have also been able to deliver on performance objectives”.

The S&P 500 ESG index, for example, has risen 6.6 per cent this year, as of August 13, comfortably better than the 4.4 per cent return of its traditional underlying index.

$32bn Net inflows to ESG ETFs in first six months of 2020

Few serious investors would read too much into such short-term performance measures, however, given that they may largely be driven by cyclical sectoral swings — after stripping out energy stocks, for example, a sector largely shunned by ESG funds, the S&P is up 6.3 per cent.

Mr Buxton argued that the expanding range of ESG ETFs, encompassing funds that exclude companies in undesirable industries or with poor ESG scores as well as those that actively favour businesses perceived to be ESG leaders, was a further attraction.

ESG ETFs and exchange traded products saw net inflows of $32bn globally in the first six months of 2020, according to data from ETFGI, more than triple the $10bn in inflows witnessed during the same period last year. This took overall assets to a record $88bn.

Mr Rajan said he had “no doubt” that ESG investment would be increasingly funnelled into passive vehicles, because passive investing was cheaper than active approaches.

But he also cited the influence of defined benefit pension schemes. These schemes, often closed to new money, “have their liabilities maturing at an exponential rate”. This means, they want to remain invested for a shorter period of time than would have been the case 10 years ago and have less need for active managers.

Mr Rajan said he expected the shift even though many investors were suspicious of “dubious” data being used to select some of the ESG index constituent companies and were concerned that passive funds did not engage sufficiently with the companies they invested in.

The Invesco research also found that two-thirds of institutional investors believed the Covid-19 pandemic would accelerate the push into ESG in the next two years, with just 4 per cent disagreeing.

Mr Buxton said many institutional investors had already made a decision to increase their allocation to ESG in the past 18 months but “for a number of reasons had not done so”, in part because they did not want to trigger gains on the investments they already had for tax reasons.

However, given the sell-off at the start of the year, “as people have come back into the market there is a natural point to re-evaluate how they come back”, he added. “ESG was at the front of the queue.”

$88bn Overall assets invested in ESG ETFs by the end of June 2020

As evidence, he cited Bloomberg data showing that in the first seven months of 2020 in the Emea region, equity ESG ETFs attracted net inflows of $13.9bn while traditional equity ETFs had seen net outflows of $7.7bn.

“There is a belief that companies in ESG are capable of long-term investment outperformance, that they are well run companies that have adapted to the future,” added Mr Buxton.

Invesco modelling forecasts that the assets of ESG equity ETFs will surge from $50bn to $300bn in Europe by the end of 2024, with corporate bond ESG ETFs also seeing rapid growth from a lower base.

Mr Rajan agreed the pandemic was likely to accelerate the trend. “It has made investors more keen on ESG because they realised the extreme fragility of the planet,” he said.

Not everyone may be quite so high minded, however. Mr Rajan said some investors were simply looking for a “bandwagon premium” as they jumped on the ESG trend.

“The March market rout opened up lucrative entry points,” he added.

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