Key Points:
- Passive ESG investing is becoming more active, challenging the idea that it is truly passive.
- ESG indexes have different levels of ESG uplift and tracking error, making it important for investors to evaluate ESG strategies carefully.
- The integration of ESG data can lead to more concentrated portfolios with lower ESG uplifts and higher active risk.
- Portfolio construction techniques can help improve the efficiency of ESG investing and achieve ESG objectives with less active risk.
- Integrating style factors with ESG objectives can enhance the investment thesis and potentially lead to excess returns.
Assets invested in passive environmental, social, and governance (ESG) indexes have been increasing in recent years, with global ESG assets under management reaching $18.4 trillion in 2021, up from $2.2 trillion in 2015. However, the active risk of popular ESG indexes is also on the rise, raising questions about the passive nature of ESG investing.
ESG investing is inherently active due to the lack of consensus on sustainability criteria and the evolving data sets and exclusions. As a result, investors need to evaluate ESG strategies based on the drivers of risk and return. For example, popular ESG indexes exhibit different levels of ESG uplift and tracking error, indicating the need for careful assessment.
One of the main drivers of active risk in ESG indexes is idiosyncratic risk, leading to differences in weights among index components. For instance, the MSCI US ESG Leaders Index has a higher overweight to Microsoft and an underweight to Apple compared to other indexes, resembling traditional active management more than passive investing.
The lack of consistency among ESG indexes and the wide dispersion in risk levels require investors to align their ESG objectives with their chosen strategy. They must also ensure that the level of ESG is commensurate with the active risk taken and stay vigilant in the evolving ESG landscape.
While higher ESG content has historically necessitated higher active risk, modern portfolio construction techniques can help improve a portfolio’s efficiency when integrating ESG content. By establishing a baseline and analyzing achievable active risk levels at varying degrees of ESG uplift, investors can identify opportunities to achieve multiple ESG objectives with minimal increase in active risk.
Integrating ESG content with style factors, such as value, momentum, low volatility, and quality, can further enhance the investment thesis. These style factors exhibit no strong bias to ESG dimensions and offer diversification potential for ESG investors. A hypothetical portfolio that incorporates significant multi-factor content can achieve robust ESG objectives with less risk compared to passive ESG indexes, while also incorporating proven sources of excess return.
Ultimately, the integration of ESG data requires active decision-making and revisiting as data improves and investor preferences change. It’s important for investors to focus on the drivers of return and evaluate ESG strategies based on their merits rather than categorizing them solely under the “ESG” subheading.
