The Case for Active Management in ESG

Perhaps the most dominant trend in the mutual fund industry over the past several years has been the rise of passively managed, index-tracking mutual funds and exchange traded funds (ETFs), which have supplanted a large portion of actively managed assets under management. According to the Investment Committee Institute (ICI) , actively managed domestic equity mutual funds experienced outflows every single year over the period from 2010 to 2017. More recently, outflows have gathered pace, totaling $844 million over 20152017. Meanwhile, ICI data shows indexed domestic equity mutual funds and ETFs have experienced consistent inflows over the same period. Morningstar, while providing slightly different figures, tells the same story.

Another trend has been the growth of socially responsible investment under a variety of labels, including sustainable investing, socially responsible investing (SRI), impact investing, and, most broadly, environment, social, and governance (ESG) investing. Similar to passive funds and ETFs, ESG assets under management in mutual funds have grown rapidly, rising from $118 billion in 2001 to $1.7 trillion in 2016.1 Given these numbers, it’s no surprise that the passive crowd wants into the ESG space, using systematic indexing techniques to replicate ESG screening strategies. Recently, a major index fund provider filed with the Securities and Exchange Commission to create a US stock ETF and an international stock ETF that will screen for ESG factors. According to the firm’s website, the funds will use “exclusionary” (negative) screening as well as “inclusionary” (positive) screening to select companies that rank highly on ESG criteria.

Negative screening is straightforward. Companies that produce/distribute alcohol, tobacco, fossil fuels, weapons, etc. are eliminated from consideration. Sophisticated ESG investing, however, has moved beyond negative screens as the primary driver of portfolio construction. Today’s ESG investor seeks to identify companies that are setting the standard in environmental, social, and governance policies and practices, or companies that have committed to moving toward best practices with specific, measurable signposts to gauge progress. The firm mentioned above does reference “inclusionary” screening, and index providers have already designed quantitative systems that aggregate ESG data, rank companies according to their scores, and select the top tier. Even so, these quantitative ranking systems retain “black box” elements, making it difficult for investors to truly understand what they’re getting.