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Man vs machine: plotting the path of passive ESG

Man vs machine: plotting the path of passive ESG

Environmental, social and governance (ESG) screening has become increasingly commonplace in actively-managed portfolios but it has recently been gaining ground in the passives space as well.

ESG indices and ETFs are in their relative infancy, with leading player iShares releasing its first sustainable product, the iShares Sustainable MSCI Global Impact ETF, in April 2016.

Switzerland is not being left behind in this emerging area, with the formation of ESG investment groups, forums and the creation of domestic ESG indices.

Ready for takeoff

Showcasing this trend, Geneva-based wealth manager 1875 Finance is set to launch what it believes to be the first Swiss sustainable indices covering developed markets for both equities and bonds, the group exclusively told Citywire Switzerland.

The indices will be created using ESG information from RobecoSAM, while S&P Dow Jones will collaborate on index construction.

Once the indices have been created, 1875 Finance plans to launch a range of ETFs, as well as segregated mandates for pension funds and institutions.

1875 Finance managing director, Edouard Crestin-Billet, believes the time is right for passive ethical investment options. ‘We are convinced sustainable indices are the right answer for the integration of ESG criteria because we are able to offer a replicable process and a solution that reduces market biases.’

Two years in the making, 1875 Finance’s sustainable equity indices are set to be market neutral in terms of sector and country, while its bond equivalents are market neutral in terms of duration, currency and credit categories.

Crestin-Billet said the inefficiency of active sustainable asset management has caused it to underperform the wider sector over the past five to 10 years because of market and sector biases.

Bumps on the road

Although there’s clearly appetite for ESG indices, the thorny question of how screening processes inherited from active approaches can be systematised remains an obstacle to growth.

Geneva-based boutique Conser Invest’s Natacha Guerdat believes passive approaches to ESG investment are viable, but certain strategies will prove extremely challenging to replicate.

‘The passive strategy will follow the bias of the ESG index, and the sustainability level of the funds will therefore not be identical to active funds. Hence, the construction of ESG indices is not feasible with every sustainability strategy.’

Passives work well with negative screening or best-in-class approaches, as they rank or exclude companies based on public information and published controversies rather than fundamental analysis.

‘Other investment philosophies – such as the integration of material ESG information in investment decisions or positive screening, which relies on a more structured and thorough assessment of stocks – are more challenging to replicate.’

Guerdat says themes such as clean energy and climate change, will perform better than water-focused strategies because of the lower need for detailed analysis.

‘In areas such as clean technology or energy efficiency, we believe there is strong added value from an active strategy that integrates micro as well as macro analysis.

‘When constructing a sustainable portfolio it can make sense to have exposure to passive funds, but you will miss interesting investment opportunities from an impact and performance point of view if the entire portfolio is passive.’

Power games

There’s also the important question of whether passive approaches to ESG can exert pressure on industries to improve their standards in the same way as active approaches.

Hendrik Jan Boer, senior portfolio manager of sustainable equity strategies at NN Investment Partners, says index investment has tended to reduce shareholder influence, as passive managers lack the resources to engage with companies and are hampered in ‘voting with their feet’ as they track an index.

He also questions the ability of a simple score to encapsulate a company’s sustainability ethos.

‘A firm like Volkswagen scored reasonably well in SRI data, as it has necessary policies in place. But policies alone are not a guarantee that such companies won’t end up in a major controversial situation.’

Although ESG factors have gained traction in the active space, the passive sphere is still taking baby steps towards integration. The replicability of the strategies may not be as straightforward, but the Swiss market is certainly playing its part in blazing a trail in unchartered territory.

This article originally appeared in the September 2016 edition of Citywire Switzerland magazine.

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