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Portfolio > Portfolio Construction > ESG

ESG Investing Doesn’t Mean Avoiding Traditional Index Funds

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You don’t have to invest clients’ money in funds focused on environmental, social and governance concerns to address their preference for socially responsible assets. A traditional index fund may suffice if the fund management company has a record of voting in favor of ESG-related shareholder proposals, and more asset managers are doing just that, according to a new Morningstar report.

Morningstar studied how the 50 largest fund companies voted on 1,033 ESG-related shareholder resolutions over the past five years — excluding the votes of their ESG-themed funds — and found that support for such resolutions has grown from 27% to 46%.

DWS, Allianz Global Investors, Blackstone, Nuveen and AQR were the five most ESG-supportive fund companies over the five years from July 1, 2015 through June 30, 2019; Federated, Hartford Funds subadvised by Wellington Management, J.P. Morgan Asset Management, Pioneer Funds and American Funds were the least supportive.

During the 2019 proxy season, Allianz Global, Blackstone and DWS placed in the top five fund families in support of ESG-focused proxy votes along with Eaton Vance and Pimco; American Funds, Dimensional Fund Advisors, Vanguard, BlackRock’s iShares and T. Rowe Price were among the five least supportive of such resolutions.

But times are changing.

Looking Ahead 

Early this year, BlackRock, the world’s largest asset manager, committed to placing “sustainability at the center of [its] investment approach and disclosing its proxy votes on a quarterly rather than annual basis,” and its CEO, Larry Fink, announced that the firm will be “increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”

State Street Global Advisors CEO Cyrus Taraporevala said his firm “will take appropriate voting action against board members” of companies included in the leading global stock market indexes that lag in addressing financially material ESG issues, based on State Street’s proprietary measurement.

“Everyone will be watching their voting records; it will interesting to see how those records change,” says Jackie Cook, director of manager research and co-author of the Morningstar report.

There’s plenty of room for improvement. According to Morningstar, BlackRock voted in favor of ESG-related shareholder proxies just 7% of the time, the same as Vanguard, and State Street’s approval rate was 27%. Of the remaining fund families in the top 10 by assets, only DFA, at 1%; T. Rowe Price and American Funds, at 11% each; and Fidelity’s active funds, at 17%, scored lower than State Street.

Vanguard, the second largest asset manager, has been “very loud in its silence” on ESG-related proxy issues, says Cook.

Other asset managers substantially increased their support of ESG shareholder proposals in 2019, including American Century, Lazard, MFS and Geode Capital Management, which manages Fidelity’s index funds, according to Morningstar.

Passive vs. Active Funds 

The Morningstar report poses a challenge to the conventional view that passive asset managers are less equipped to manage assets that focus on sustainable assets outside their ESG-focused funds because they can’t influence corporate behavior by selling shares. They have to own the index.

That condition, however, puts “more responsibility on those funds to actively vote” on ESG-related shareholder proposals, says Cook. “Their risk is systemic risk, which can impact the market as a whole. They have a real interest in watching out for climate risk, for accountability and more, and they are in a powerful position to address those risks in proxy voting … to consider the material risks that affect the financial system related to ESG factors.“

Moreover, their proxy votes can make a far larger impact than those of smaller, actively managed funds, which are better equipped than passive funds to engage with individual companies on ESG-related issues.

The SEC’s Proxy Proposals

The growing interest in ESG-related shareholder proxies among asset managers comes at a time when the Securities and Exchange Commission has proposed new rules that will essentially restrict the number of shareholder-supported proxy votes, including those related to ESG issues.

One proposal raises the stock ownership threshold to sponsor a first-time proxy proposal and increases the minimum voting percentage required for resubmissions in subsequent years, which sounds unusual but is very common.

Another proposal would require proxy advisor firms, which advise asset managers on votes, to include a company’s response to a proposal in the recommendations they distribute to clients. Few asset managers have commented on the SEC proposals other than a handful of sustainable investing-focused funds.

“These rules would stop some proxy issues in their tracks,” says Cook. “Some start at the margin and become more central,” based on news and developments. “Without shareholder resolutions allowed to enter at the [lower level] you don’t end up with the same level of debate later on and the market could be taken by surprise” when material investment issues develop that could affect stock prices, such as the opioid crisis on drug stocks and mass shootings on gun manufacturers. “The groundwork has been laid.”

Morningstar opposes the SEC proposal that would limit proxy resubmissions, noting in its comment to the agency that the proposed rule “would stifle investors’ voices” when it comes to corporate governance.

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