London – Ethical and sustainable investors using passive strategies are missing out on a wealth of opportunities overlooked by the rules-based investment products, according to Kames Capital’s Ryan Smith.
While such trackers have grown in popularity in recent years, Smith believes there are a number of drawbacks to the products which can hamper investment performance.
Smith, head of ESG research at Kames, says many trackers can end up with overweights in large cap companies because those stocks put out the most disclosures when it comes to their sustainable practices.
There are also concerns about the ability of passives to engage with companies they own to improve ESG outcomes, notwithstanding issues around the individual outlook for companies which are included in such indices.
“The Kames Global Sustainable Equity Fund invests in sustainable companies of various sizes, stages of development and across geographies, because we believe this is the best way to add alpha,” he says.
“In comparison, passives in the sector have a number of biases which we believe can detract from their performance.”
Below Smith identifies three of his biggest concerns for investors using ethical trackers.
Large cap exposure
“Focusing predominantly on the environmental, social, and governance (ESG) disclosures that companies make can result in a bias towards certain sectors, style or markets, while overlooking other good opportunities,” Smith says.
“Such indices typically invest most of their assets in large-cap companies, but this goes against our experience when managing both our ethical and sustainability funds, where both approaches have a bias to small and mid-cap size companies.
“Indeed, the strict negative screening criteria used for our ethical funds results in a bias to small and mid-cap companies which in turn requires an experienced team to actively manage this risk.”
Geographical biases and dilution
“The indices are typically populated by developed market stocks, with little in emerging markets. However, many of the most material sustainability challenges are occurring in Asia,” Smith says.
“Therefore, investors avoiding this region are missing out on the opportunity to provide capital to the businesses providing solutions to these issues.”
As well as geographical biases, Smith adds passives can dilute the exposure to trends or themes which the products are meant to be capturing.
“Not all the companies associated with a theme will be successful, and the more companies you add to your portfolio, quite often, the more the actual theme you sought gets diluted away,” he says.
Lack of engagement
“The growth of passive investment has increased the concentration of ownership and voting rights because while passive investors can be active proxy voters, they cannot sell and they are less likely to meet management,” says Smith.
“In contrast, active investors can vote, engage and sell their shares as necessary, and typically active managers take the engagement area of fiduciary responsibility far more seriously than the passives.
“Engagement is important because even ‘sustainable’ companies need to be held to account on their corporate governance.”