Daily Times

When the East Sussex local authority pension fund in southern England wanted to cut its exposure to fossil fuels, it needed to be sure there were no oil and gas stocks in the benchmarks its passive funds tracked.

So the scheme recently swapped 200 million pounds ($271 million) out of a passive fund that tracked a traditional equity index into one that excludes oil, gas and coal companies.

That has helped it reduce its exposure to fossil fuels to below 2% of assets today — from 6% in 2016 — said Gerard Fox, chairman of the pension fund committee for the 4.6 billion-pound scheme, which has 78,000 mostly local government members.

“The greatest fiduciary risk to the portfolio from the energy transition probably lies in unconscious exposure to challenged companies and sectors via passive funds,” Fox told Reuters.

The East Sussex Pension Fund is one of many asset owners shifting their passive holdings to investment tracking indexes that promise to incorporate environmental, social and governance (ESG) factors, by, for example, excluding certain industries and companies — part of a global drive to reach net-zero emissions.

For years, the way to do this was to put more money into actively managed ESG-aligned funds where managers promise selective stock investing to beat index performance.

More recently, there has been a sharp rise in the amount of ESG-focused investment tracking indexes, including through exchange-traded funds (ETFs).

Importantly, this will likely mean more investors selling out of companies that don’t make the cut for their ESG indexes, potentially reducing their power to engage with the firms to push them to go greener in their businesses.

In 2021, the share of all ETFs assets held in products with an ESG label jumped to 18%, against 2020’s 10% share, according to data from Deutsche Borse. In 2017, the share was below 1%.

Investors ploughed record sums of cash into ESG ETFs, and asset managers also converted their traditional funds into ESG-friendly products by changing the index they track.

The trend is particularly pronounced in Europe — Amundi (AMUN.PA), Europe’s biggest asset manager, said 95% of all net inflows into its ETF range last year went into ESG funds.

Overall, more than half of market-wide net flows into Europe-domiciled equity ETFs went to ESG-labelled funds, while two-thirds of new ETF launches were ESG-labelled, data from State Street Global Advisors showed.

Manuela Sperandeo, head of sustainable indexing for Europe, the Middle East and Africa at BlackRock (BLK.N), the world’s biggest asset manager, said improved understanding of index track records, “better availability of data around net zero, together with the sustainability regulation impetus” would accelerate the trend in 2022.

BlackRock has been working with a growing number of asset owners about moving their passive holdings to ESG-aligned benchmarks, she said, citing agreements with Oxford University and ongoing discussions with several Nordic and Dutch asset owners about swapping to a climate benchmark.

While the bulk of ESG switching has been in equities, where benchmarks have a longer track record, Sperandeo said investors would increasingly look to do the same for fixed income and other parts of their portfolio.

Passive investing has transformed markets as investors – preferring shadowing indexes to picking stocks – pour money into lower-cost funds run by industry behemoths including BlackRock and Vanguard. Index funds today control about half the U.S. stock mutual fund market.

The growth of passive ESG funds is significant because it will mean widespread selling of companies that don’t make the cut for new benchmarks, such as firms excluded from the East Sussex Pension Fund’s ex-fossil fuels strategy run by Osmosis Investment Management.

As near-permanent holders of a company’s stock, passive managers make much of using their power to engage with ESG laggards, so any dilution of their holdings could hamper that ability, leaving sustainability minded active managers to pick up the slack.

“Once you have excluded a company, you do not have any leverage,” said Matthieu Guignard, Global Head of Product Development and Capital Markets at Amundi ETF, Indexing & Smart Beta.

Guignard said ’tilting’ index weightings away from laggards was one way to resolve this, as investors could still pressure company boards for greater climate action.

“Some investors really want to remain invested, they want to stay universal owners and drive change through engagement efforts, all the way to others who very much at the moment want to divest very quickly. This is the European lens,” said BlackRock’s Sperandeo.

For East Sussex, fossil fuel businesses are unlikely to find their way back into passive portfolios unless they themselves go green.

But Fox said the scheme didn’t believe in “blanket whole portfolio divestment”, and fossil fuel exposure should be confined to active managers who engage with the companies.