bfinance insight from:

Weichen Ding
Weichen Ding
Director, Equity

Kathryn Saklatvala
Kathryn Saklatvala

Senior Director, Head of Investment Content

From the pages of the Financial Times and Reuters to the hallways of investment conferences, noise of an ‘ESG Backlash’ has echoed around the asset management industry through recent months. 'Exhibit' A for naysayers: ESG equity indices, with prominent examples delivering below-market performance over the past three years. Yet not all ‘passive ESG’ is created equal. Investors can consider very different types of strategy as well as varying approaches to implementation, from custom indices to optimised replication techniques.

Before the Covid-19 pandemic, study after study reinforced a core message: ESG does not detract from performance. For example, a 2019 report from the Morgan Stanley Institute for Sustainable Investing (Sustainable Reality: Analyzing Risk and Returns of Sustainable Funds) found “no financial trade-off in the returns of sustainable funds compared to traditional funds,” as well as evidence that they “demonstrate lower downside risk” and “are more stable.”

Evidence of non-concessionary returns helped to propel ‘passive’ ESG equity to the investment mainstream, along with other supportive factors such as more credible index construction methodologies, greater breadth and depth of data (including forward-looking climate data), improved evidence of active ‘engagement’ and, of course, strong proactive marketing efforts. From its humble origins in 1990, when KLD’s Domini 400 Social Index was launched, passive ESG became a flourishing sector with well over a thousand indices—primarily in equities—spanning environmental, social and broad ESG themes.

The post-pandemic era, however, has brought a shift in gear. While 2020 proved to be a positive year for the performance of passive sustainability strategies, 2021-22 were distinctly problematic and 2023 saw a continuation in the underperformance of climate-aligned indices.

Source: MSCI. Performance measured in US Dollars.
Indices are not investible and do not represent performance; it is not possible to invest directly in an index.

Underperformance can be attributed to specific tilts and exclusions. For example, 2022 punished energy under-exposure, while 2023 saw ESG strategies over-exposed to clean-tech and underweight in the runaway big tech stocks.

Source: Bloomberg
Indices are not investible and do not represent performance; it is not possible to invest directly in an index.

Scientific Beta, among others, made waves in 2023, with a report evidencing the underperformance of sustainable index funds over a decade-long period (Sustainability Alpha in the Real World: Evidence from Exchange-Traded Funds). Such evidence provided the opponents of ESG investing—particularly those on the right of US politics, where ESG investments by pension funds have long presented a political football—with fresh ammunition.

While short-term underperformance of active ESG strategies can be debated away through a variety of acceptable stylistic and strategic arguments, ‘passive ESG’ is perhaps more vulnerable to such critique. Those constructing indices often explicitly seek to minimise undesired sector/style tilts, precisely in order to reduce the probability of damaging deviations.

The performance picture has helped to drive what is now an identifiable shift in tone among some of the largest asset managers in the world – including key players in passive ESG equity. From website language and marketing collateral, to in-person conversations, some managers’ messages are migrating: ESG is to be framed as a ‘client choice,’ rather than promoted as an intrinsic firm-level philosophy.

Nuances in passive ESG implementation

These debates make it more important than ever for equity investors to understand the complexities of ‘passive ESG’ investing. While passive investing is often perceived as a rather straightforward subject, the integration of Environmental, Social, and Governance (ESG) considerations is a complex affair, particularly for an investor who strives to maintain low tracking error and affordability. Investors, especially now, must make careful and robust choices that reflect their own objectives, philosophy, tolerance for tracking error, cost sensitivities and the long-termism (or otherwise) of their governance framework.

Implementation option 1: track an existing ESG index

The most straightforward method for incorporating ESG into passive portfolios is by tracking established ESG indices, such as MSCI ‘ESG Leaders’, MSCI ‘Climate Change’ or Solactive ‘Paris-Aligned’.

Tracking an existing ESG index has the advantage of simplicity: investors can benefit from a range of existing funds that already do so. This makes it more cost-efficient than the heavily customised routes (options 2 and 3, below). That being said, index licensing fees for ESG indices are generally higher than those for non-ESG indices (the complex and important subject of cost is discussed further below).

The selection of an appropriate ESG index is far from simple. Available indices range from the very broad to the more narrowly thematic, including those with specific environmental or social themes (climate, women’s leadership, minorities). Even among indices with a similar stated mission, one finds a range of methodologies and differing levels of tracking error versus the market, not to mention various approaches to pricing. The climate cohort is itself extremely diverse, and evolving in favour of more forward-looking approaches that capture projected changes in emissions, rather than relying on past emissions).

In all cases, index construction begins with a parent index that provides the initial investment universe, followed by the application of an ESG methodology (exclusions, integration, thematic filters) to narrow the universe to a smaller set of companies. These are then weighted based on the index’s rules. Further guidelines govern rebalancing frequency and other adjustments.

Importantly, the index may not be fully aligned with the investor's specific ESG preferences. This could necessitate some additional tailoring through further screens or portfolio adjustments, which can be applied by the asset manager for an additional fee.

Implementation option 2: create and track a custom ESG index

Investors can collaborate with index providers to create a bespoke index that aligns with their ESG criteria, objectives, and constraints. Both MSCI and passive equity managers have, in recent years, reported an increasing number of investors seeking customised indices, typically focusing on specific ESG themes or SDG goals.

These generally involve (even) higher licensing fees and a greater initial outlay of effort on the part of the investor, but the tracking process thereafter aligns with conventional methods, enabling portfolio managers to apply typical return enhancement strategies.

This approach offers limited flexibility for regularly updating ESG criteria. It also demands careful selection of both an appropriate provider for the index and a manager for tracking it, with a sharp eye on cost.

Implementation option 3: use optimised replication versus a broad market index

Contrary to what investors may anticipate, a ‘passive-like’ or rules-based ESG equity strategy does not necessarily require an ESG index – existing or bespoke. Instead, an asset manager can use a broad market index and then apply optimisation techniques to build a portfolio that meets ESG requirements. This may help investors that are keen to reduce tracking error against a mainstream market index, since quantitative methods can be applied to achieve this objective. It is particularly suitable for investors that have extensive stock exclusion lists or more complex climate-related requirements, such as carbon reduction targets, that an asset manager can implement.

This approach requires significant attention and effort from the selected asset manager (though, from a pricing perspective, the associated expense may be offset by the much lower index licensing costs since a mainstream market index can be used as the starting point). It also demands higher expertise: managers must be proficient in optimisation techniques and mindful of various factors needed to manage the portfolio appropriately.

Understanding cost complexity

As has been noted above at various points, there are significant cost considerations that investors should bear in mind when determining an approach: while the term ‘passive’ is often used to describe this type of strategy, the costs involved are far higher than conventional passive investing and are not always straightforward or transparent.

There are two main components to cost, not including the expenses that an investor may incur in-house (resourcing/staff, direct charges from the index provider, et cetera). These are the investment management fee and the index licensing fee. Moreover, investors that need reporting (e.g. climate reporting for regulatory purposes) can subsequently be hit with unexpected additional data charges that were not understood during the establishment period; these can be large and may become visible after the point when an investor can realistically change provider (e.g. they’ve begun licensing a customised index).

As discussed above, licensing fees for ESG indices are typically higher than standard market indices (by around 0.5-1 basis point, depending on the level of ESG integration and complexity involved). For custom indices (Implementation Option 2), investors can expect a further premium. Moreover, investors can encounter a lack of transparency. A passive fund manager will not only pay for the index provider rights to use the index; they will also usually pay an additional fee per annum based on the AuM linked to that index (often expressed in basis points). The pass-through of these costs to the investor client is not always evident or transparent. Certain index providers may not permit asset managers to disclose the licensing fees. Furthermore, data for reporting—such as climate reporting—involves additional cost (which can be borne by the manager, the investor or both); security-level climate data is particularly expensive and investors may not always realise that this data is not included as part of the index licensing arrangement.

Index providers and asset managers: some questions for investors to consider

  • What % of the manager’s stated fee is attributed to index licensing costs?
  • Does the investor need to pay an additional index licensing fee, or is it already included in the managers’ stated fees?
  • Do the stated fees incorporate access/use for all data that would be needed to satisfy the investor’s stated reporting requirements, or would additional charges/purchases be anticipated to fulfil these?

Meanwhile, investment management fees vary considerably depending on mandate size, whether implementation is carried out via a separately managed account (SMA) or a pooled fund, and the extent of any additional customisation requests. Pooled funds are popular when tracking an existing index, though an SMA may be appropriate; Implementation Options 2 and 3 (above) are most commonly executed via SMAs, although a manager may create a pooled fund with a seed investor if they envisage broader appetite. For pooled funds, an investor could broadly expect an overall TER of 10-20bps for an ESG passive strategy (including investment management fees, fund administrative fees and operational costs), versus around 5-10bps for a conventional passive strategy and 50-80bps for an active strategy. For SMAs, there is a difference in investment management fees between the more straightforward approaches (Option 1) and the more customised approaches (Options 2 and 3)—we note a differential of 2-3bps on a USD300 million SMA for the more customised approaches (Options 2 and 3) versus the more straightforward approach (Option 1)—but this customisation premium effectively shrinks with larger mandate sizes.

In short, cost management in this space is complicated and investors must select and negotiate with care in order to avoid bearing an undue burden.

Balancing act

Implementing ESG considerations into passive equity investing requires a thoughtful balance between adhering to a ‘passive’ investment philosophy and achieving desired ESG and/or climate outcomes. Investors can consider a variety of options and determine what will best suit specific needs. A robust understanding of different approaches can also make it easier to navigate through current controversies and address performance concerns with confidence.

Important Notices

This commentary is for institutional investors classified as Professional Clients as per FCA handbook rules COBS 3.5R. It does not constitute investment research, a financial promotion or a recommendation of any instrument, strategy or provider. The accuracy of information obtained from third parties has not been independently verified. Opinions not guarantees: the findings and opinions expressed herein are the intellectual property of bfinance and are subject to change; they are not intended to convey any guarantees as to the future performance of the investment products, asset classes, or capital markets discussed. The value of investments can go down as well as up.