The Covid-19 crisis is a stark reminder of the vulnerability of human societies and our dependence on the balance of natural systems. It is true for health issues but also for biodiversity and climate issues. Some observers even argue that climate change could foster the emergence of future pandemics, as global warming could facilitate the spread of viruses held in check by colder temperatures. That’s why investors of all kinds must work towards a more sustainable model — and both active and passive asset management have critical roles to play.
It is often suggested that only active managers can contribute to reaching sustainable development goals. This argument is flawed. Index-based investing is a key actor in driving the sustainable finance transition for two reasons. The first is that index providers are providing sophisticated, science-based sustainable benchmarks. It’s simply incorrect to argue that the benchmarks of index-tracking funds and ETFs are necessarily backward-looking and are therefore insensitive to the risks of climate change. Europe is an example of change.
The EU has been working to introduce two types of carbon transition indices, the EU Climate Transition and EU Paris-aligned benchmarks. These benchmarks are a radical approach by EU policymakers. For the first time, indices are being used explicitly to help orient investor choices and to redirect investment flows. Both indices are aligned with a 7 per cent decarbonisation trajectory, in keeping with the Intergovernmental Panel on Climate Change’s scenario of a maximum 1.5 degree temperature increase. For the first time, indices will have a carbon reduction goal in absolute terms. Data requirements also argue for index-based investment. The sheer amount of information needed to ensure that a portfolio follows a set decarbonisation trajectory, or targets a given temperature warming level, calls for a quantitative investment approach. This is best achieved via an index rather than via stock-picked alpha.
If we want to have a chance to shift capital at scale while doing it in a transparent and disciplined way, the passive approach has a clear part in the process. Index fund investors have already been voting with their euros, dollars and pounds to make the shift en masse to sustainable investing. Lyxor calculates that, as at June 2019, passive ESG fund assets had grown at a rate of 33 per cent per year over the past five years, three times faster than the growth of active ESG funds during the same period. The second reason for index funds playing a critical climate transition role is that the managers of these funds’ assets are ideally placed to engage with corporate management.
Far from being absentee landlords, index fund managers have the unconstrained ability to influence corporate behaviour through voting — in some ways even more so than active managers. Index-based managers are invested in portfolio companies for as long as those companies form part of the relevant index. Rises or falls of an individual stock are therefore of no consequence — it is ultimately the tracking of the overall index that matters. In contrast, choosing to vote for a resolution that may benefit a more sustainable economy, but could hurt an individual company’s share price short term, can be a tough responsibility for an active manager to take on. This is not to pit active against passive when it comes to voting, but only to stress that voting can be a potent tool in the hands of passive managers, because the act of voting is by nature for them disconnected from that of portfolio management per se.
Equating index-based investing with the inability to vote simply misses the point: not only can index-based managers use their vote just in the same way as active managers, but they also have the unfettered ability to use their vote to advance causes that matter to investors, such as sustainable investment and the fight against climate change. Lyxor has no axe to grind in the debate over active and passive management since we offer both products. As a large European ETF provider, we can be “very active in passive”, using our vote to make a difference for our clients. The reasons why index-tracking funds and ETFs have grown seven-fold in size since 2008 and doubled their market share to about 20 per cent of global assets under management are well-known. Passive funds still have a significant cost advantage over their active cousins, the indices they track are transparent and they offer easy diversification across a range of asset classes. With continuing growth in indexing, it is inevitable that, as evidence of the climate crisis mounts, ETFs will play a lead role in driving the sustainable finance transition.