The way active managers thought and spoke about ETFs changed when ETFs started to gather significant assets under management.
At the beginning, ETFs were seen as a gimmick that would be used by a small number of investors. As time went by, however, active investors realised ETFs have the power to eat a large portion of their revenues and so they started to say ETFs represented a threat for the financial markets.
As a result, there were several investigations from market regulators on the impact of ETFs on markets in times of turmoil, as well as on more general topics such as possible issues related to illiquid holdings within an ETF’s underlying index. All these investigations proved that ETFs are very efficient investment vehicles, and the subsequent investigations concluded they did not harm the markets. Despite these results, critics don’t stop to raise concerns about passive investment strategies.
As passive ESG-related funds and ETFs have started to gather a significant market share from the overall flows into ESG products, it is no surprise some market participants are starting to blame passive ESG-related products as being inappropriate for the implementation of a sustainable investment strategy.
One of the major claims from the critics is the managers of passive products don’t have an opinion on markets or companies, as they “simply” buy the constituents of an index with the same proportion as in the index. This means the fund manager does not make any discretionary decisions and may therefore not engage with the boards of the companies within the portfolio and may also not vote at the annual shareholder meetings.
Even as it is true that the portfolio of an index fund should replicate its respective benchmark index as closely as possible, a large number of promoters of passive products proved their critics wrong on the engagement front. This is because they have well-documented processes with regard to their engagement and voting policies. This does not mean these processes are as strong as those from specialised actively managed products, but they are in many cases at least somewhat on the same level that one can observe of the average active manager.
In addition, critics claim some of the constituents within the portfolio of an index fund might be inappropriate for an ESG strategy, as the index may follow a best-in-class approach, which means the index may contain the most sustainable oil service company, etc. Obviously, this claim is true, as it is the nature of a best-in-class approach and, therefore, these holdings can also be found in actively managed ESG funds with a respective management approach.
More recently, the fact that ESG-related indices are mostly based on a quantitative approach has become a topic for critics, since such an approach can lead to an overweighting of large companies from developed countries. This is true, since large companies have specialised departments that produce the data, statistics, and ratios needed by data vendors and ESG rating agencies to run their quantitative analysis. That said, active managers also use a quantitative analysis to select groups of companies on which they will run further qualitative analysis.
The discussions around passive ESG strategies are meaningless, since most of the topics raised by critics have been proven wrong or are also true for actively managed portfolios. Therefore, these discussions can be seen as marketing efforts to steer investors in the direction of actively managed funds.
These claims are only adding to the feeling of insecurity with regard to the right investor strategy for ESG investments and may rather hold investors back than help them find the product that suits their needs best.
ETFs enable investors to make educated decisions since they are highly transparent with regard to their portfolio constituents. In addition, one can normally also find a detailed description of the methodology which is used to build the underlying index. This high level of transparency is converse to the black box approach of active managers.