Some investors are convinced that, to align their portfolio with their ESG principles, they must use an active, rather than passive, manager. After all, this reasoning goes, how can I invest in the “good” companies without someone to hand-select them for me? Not only is the underlying assumption here false, but there are two key reasons an index-based approach may be the better way to participate in responsible investing.
Returns vs. principles: the active manager’s dilemma
The reason investors choose an active strategy is rooted in the conviction that the manager will outperform a given benchmark on a net-of-fees basis. This doesn’t change just because responsible investing is part of the equation. An active manager who diligently selects investments based solely on their ESG characteristics while ignoring potentially poor returns isn’t one a client will stay with, no matter how committed that client is to a given ESG issue.
Now, there may be certain securities that offer both appealing expected returns and what the active manager views as “good” ESG characteristics (more on this in a bit). But sometimes those two goals are in conflict. When that happens, the manager is faced with a dilemma: either maximize returns at the expense of the client’s ESG goals or prioritize ESG considerations at the expense of the client’s returns. In this case the active manager may seek to further narrow an already slim band of attractive stocks or, alternatively, widen the investable universe with securities whose expected returns wouldn’t have otherwise made the cut.
The reality is that forecasting returns is a murky endeavor—even when responsible investing isn’t involved. As a result, when returns fall short of expectations, it’s hard to say whether it’s the ESG criteria or just poor financial forecasting. But the tension between ESG criteria and expected returns does create challenges that are unique to active management—challenges that aren’t intrinsic to responsible investing. If investors seek instead to simply match a benchmark return, this tension is resolved. Thus, through a passive strategy, they can see a more nuanced interpretation of their principles—one in which the diversified nature of the holdings can moderate any potential performance impact.
Who decides which companies are “good”?
Working with an active manager means accepting that manager’s interpretation of what makes for a company with good ESG characteristics. What’s more, the investor is likely to receive only minimal insight into what factors into that interpretation.
That said, in fairness to the active manager, there’s little consensus around the definition of responsible investing. And it’s not because the market for ESG isn’t mature. Rather it’s because this kind of investing is intensely personal and means different things to different people. Public companies are large, complex entities with both attractive and unattractive attributes, and not all investors agree on which are which. Even if there were consensus on things like nondiscriminatory hiring practices or clean supply chains, how to actually measure and prioritize these values in the stock-selection process is highly subjective. And so for investors with their own clearly articulated priorities, someone else’s idea of what makes for a “good” company can be hard to swallow.
This is where a passive approach has another advantage. It allows investors to separate the return objective from the ESG objective and regain control over the prioritization of nonfinancial issues. How? A central tenet of passive investing is that market prices are a good approximation of a company’s fair value. So, the thinking goes, trying to identify “underpriced” securities often isn’t worth the cost of doing so. Instead it’s better to have a starting universe of hundreds of securities, rather than tens, that are acceptable from a return perspective.
For socially responsible investors, this means that securities that meet both their desired expected return and ESG objectives are far more numerous. This gives them much greater latitude to prioritize—and customize—ESG criteria without worrying about overly limiting the universe of eligible investments. Although responsible investing may introduce some difference in returns relative to a benchmark without ESG criteria, a passive manager should be able to build a diverse portfolio that both meets the investor’s ESG goals and generates returns comparable to those of the benchmark.
The bottom line
If investors decide to work with an active manager, it should be because they’re convinced that manager will outperform a passive approach and not because they think they need an active strategy to achieve their responsible-investing goals. Is it possible an actively managed approach and an investor’s ESG objectives can align? Sure. But in our experience, investors may find it hard not to compromise either their ESG or their return goals. In contrast, a passive approach to responsible investing can help investors pursue both objectives without making concessions.
Potential Parametric Solution
For more than 20 years, our Responsible Investing capability has offered a robust and continually evolving menu of ESG screens and licensed indexes, giving investors a wide range of portfolio design choices. In addition, our proxy-voting guidelines follow corporate-governance best practices to safeguard shareholder capital, and they consider the relevant environmental and social implications of management and shareholder proposals.
Jennifer Sireklove, CFA - Director of Responsible Investing
Ms. Sireklove oversees all aspects of Parametric’s Responsible Investing Strategies. As the primary strategist for responsible investing, Jennifer works closely with advisors and consultants to design, develop and implement portfolio solutions that incorporate their clients’ principles.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.