Dynamic solutions for sustainable "passive" investing
One of the biggest investment trends over the past decade has been the shift from active to passive investing, with investors being attracted by lower fees and simplicity. Another popular trend is sustainable and responsible investing. Can passive investment strategies supplement active ones to further grow sustainable investing?
One of the biggest investment trends over the past decade has been the shift from active to passive investing, with investors being attracted by lower fees and simplicity: in Europe, passive investing represented 16% of total funds managed in 2017, up from 12% in 20101. Another popular trend among investors is sustainable and responsible investing: globally, sustainable investing assets stood at $30.7 trillion at the start of 2018, a 34% increase in two years2. And in 2018, the European Commission launched a ground-breaking Action Plan for Financing Sustainable Growth, with the aim of creating new tools to mainstream sustainable investing.
The real question is whether these two investment processes can be combined. Staying away from a binary debate, can passive strategies supplement active ones to further grow sustainable investing? The pragmatic answer to this rather rhetorical question is that “passive” investing, usually tracking a market-weighted index, can be redefined as a “systematic dynamic” investment process, embedding Environmental, Social and corporate Governance (ESG) considerations. And the easiest and most efficient implementation of such a process is the creation and adoption of an index integrating ESG selection filters.
A range of solutions to incorporate ESG in indexing
Just like in other ESG investing solutions, the integration of ESG criteria when creating an index can be made as an exclusion approach, a positive selection of best-in-class or best-in-universe companies, or along a specific ESG thematic, each of these methodologies serving different purposes and investor priorities.
Selecting top ESG performers in the entire eligible scope is called a Best-in-Universe strategy, whereas a Best-in-Class strategy selects ESG leaders sub-scope by subscope, a sub-scope typically being a sector of activity. The Best-in-Class implementation has the appeal of maintaining a sector diversification in line with that of the investment universe; investors also implement it to foster best ESG practices in all sectors.
Thematic indices can be created along multiple Environmental, Social, or Governance themes. There has been, for instance, great traction since 2015 towards indices that are geared to one or several of the 17 United Nations Sustainable Development Goals (UN SDG), like Clean Water and Sanitation, Responsible Consumption and Production, Affordable and Clean Energy or Gender Equality.
ESG criteria used in indices tend to focus more and more on improvement trends and forward-looking outlooks, rather than simply static current ESG performances. Also, indices always aim to combine financial performance and ESG performance: with that view, additional criteria can be taken into consideration in the creation of the index, such as volatility, liquidity or risk. Lastly, whilst most indices are capitalisationweighted or equal-weighted, ESG scores can sometimes also be used to “tilt”, in other words increase or decrease components’ weights.
The flexibility of dynamic systematic indices makes it possible to combine several of the above approaches.
A range of delivery formats
Once an index is built, its performance can be easily delivered through various means. Historically, a very popular way has been to build investment funds that track an ESG index by buying its components and minimising the tracking error. Fund managers can then exercise corporate engagement and investment stewardship.
The performance of an ESG index can also be delivered in a more synthetic manner, through an option, a swap and, more recently, futures.
Finally, tailor-made investment solutions that deliver the performance of an ESG index combined with custom financial requirements, typically a degree of capital protection, have gained significant popularity over the past few years, contributing the growth of the retail share in the sustainable investment market, which stands at roughly 25%, per the 2018 Global Sustainable Alliance Report review.
A range of benefits
A solution that uses an index is built to ease investors’ constraints, making sure that their various requirements are met. The benefits are tangible:
Transparency: the index rules are defined from the outset and applied throughout the life of the index; these include the definition of a robust governance to adapt to the various events that can affect the life of an index.
Time-to-Market: the elapsed time between the definition of the strategy and the delivery of the custom ESG index-linked investment solutions can be short, for instance a few weeks.
Open architecture: investors can designate their preferred ESG data providers.
Size flexibility: the competitive cost of creating and running an index makes it suitable for smaller investments.
Regulation: indices are governed by the European Benchmark Regulation in the EU, and the International Organisation Of Securities Commissions (IOSCO) principles from financial benchmarks globally.
The breadth of approaches, delivery formats and benefits offered by indices incorporating ESG criteria clearly make them a sound solution to deliver sustainable investment in a systematic and dynamic manner: a new perspective to “passive” sustainable investing.
Isabelle has been Head of Sustainable Investment Solutions since February 2017. She joined Societe Generale in 2006 and has held various positions within markets activities, notably as COO for the Cross Asset Structured Products activity in New-York. Since 2014, she has been a Financial Product Engineer in charge of developing cross asset investment strategies and index structuring for the Societe Generale Index franchise (SGI). Isabelle started her career in 2001 at Capgemini Consulting. Isabelle Millat is a graduate of ESSEC Business School.
(1) Lyxor ETF research insights, November 2018. (2) 2018 Global Sustainable Alliance Report.