The choice for active versus passive investing becomes more compelling when environmental, social and governance issues are layered into an investment thesis. Integrating ESG analysis into investment decisions is complex and therefore, we believe an active approach to ESG investing is needed and adds value.
ESG investing focuses socially responsible issues when selecting companies for a portfolio. However, ESG means different things to different people resulting in conflicting ESG risk profiles for the same company. In addition, company disclosures vary widely, providing inconsistent data with which to compare and construct a portfolio.
Active managers combine valuation, fundamental analysis and ESG factors into their stock selection. A passive or index strategy does not encompass individual stock selection; rather, stocks are added based on a positive or negative screen without regard to valuation or fundamental research. An active manager may create a select and concentrated portfolio (40 or 50 names) while passive funds may hold a large diversified portfolio (in some cases over 1,000 positions) that due to liquidity needs, out of necessity, can include stocks with low ESG ratings.
Vanguard’s ESG U.S. Stock ETF attracted $101 million recently, marking the largest weekly inflow for any socially-responsible fund since June, according to Bloomberg data. The fund’s assets grew 60% to $270 million. This ETF holds positions in Facebook and Amazon, which both receive low marks in various ESG metrics — Amazon for the treatment of their workforce and Facebook for its data issues. The MSCI ESG ETF also has high weightings in these same stocks, and it has exposure to fossil fuels.
Sector weightings also seem skewed for passive strategies that may favor sectors with more readily available metrics and data. For example, the Global Gender Equality ETF has a 32% weighting in financials. The S&P Fossil Fuel Reserves Free ETF has 20% in financials as well as a large weighting in technology, which include Amazon and Facebook. The large ESG ETFs all appear to own the same large cap stocks and have a heavy concentration in a few sectors.
And many of these ETFs hold stocks that have questionable sustainable records.
Active managers can sell a position when company management is not performing or up to their ESG standards, reacting more quickly to new information and independently.