Do ETFs Have a More Legitimate Role Than Active ESG Funds?

October 11, 2022

LONDON − ETF investors have a more “legitimate role to play” when it comes to ESG investing compared to their active counterparts, HSBC Asset Management’s former global head of sustainability Stuart Kirk has said.

Speaking at ETF Stream’s ESG ETFs Investor Workshop last week, Kirk said passive investors have “more skin in the game” because they own substantially more companies than mutual funds.

While active funds often claim to engage more with the companies they own, Kirk argued that by excluding so many holdings, they are merely passing the problem onto somebody else.

“Passives and ETF investors have more skin in the game because they own more companies,” he said. “They have more say in more boardrooms than the focused manager.

“They have a bigger and more legitimate role to play because they have a seat at the table. The average number of holdings in an ESG ETF is about 1,300 stocks while the average number of holdings in an active fund is 20 to 50. They have excluded so many stocks.

“The right way to have an impact, counterintuitively, is to have a broad portfolio because it has no more effect on prices than a concentrated one. They also have a morally stronger position and more skin in the game.”

Kirk highlighted the importance of engagement and said passive managers must vote their shares to have any real impact, an often-contested area in the passive space.

Last month, he slammed asset managers for divesting, just days after his former employer announced a plan to divest from its thermal coal holdings by 2040, labelling it “worse than pointless virtue signalling, and potentially harmful to the environment”.

Despite this, he said the ability of an active manager to participate in IPOs was where they could make a difference, albeit a small one. “The number of IPOs in the S&P 500 relative to the whole S&P 500 is less than 0.5%.”

Fundamentals Drive Shares Prices, Not ETFs

Kirk, who resigned from HSBC AM in July, also rallied against the theory that the growing size of the ETF market is helping to distort prices, adding it is the secondary market – such as venture capital and private equity – that makes a difference, not the primary markets.

“No amount of inflows and outflows of ETFs or passives affect the price of underlying securities. It is the fundamental cash flow and the outlook of companies decided by active managers that determines the price,” he said.

“By definition, for every seller there is a buyer and for every buyer there is a seller. It does not matter for the company one bit.”

He added this causes a problem when groups such as the Net Zero Asset Management Alliance ask for alignment because somebody always must own the poor companies.

“We cannot all be aligned because the amount of money in poor companies stays the same,” he continued. “It is immoral because you are forcing the bad companies that you do not want to own onto somebody else.”

Input and Output Investing

Furthermore, Kirk said he believes the industry needs to be more specific when talking about ESG, which is currently being defined in “two different ways at the same time”, leading to suboptimal outcomes.

One way is input investing, which is used in standard indices and takes ESG factors along with risk and return indicators of companies into account before putting them through a valuation process.

The other is output investing, which tries to pick companies based on their superior ESG scores.

“Quite often ETF issuers will flip between the two,” Kirk said. “On the one hand, they have benchmarks that are ESG input benchmarks, and on the other hand, they talk about trying to pick good companies.

“In an ESG input world, valuation matters. You could have an awful company but if it is cheap enough and that poor ESG score is in the price, you will buy it.

“It can lead to the ridiculous situation where your ESG portfolio is full of what a client deems poor companies. But in this world, you are legitimately buying them because you think they are going to outperform.”

Kirk also noted to his other former employer, DWS, was not raided by German authorities for picking "good stocks", but for not integrating ESG into its stock selection process. 

"That was completely wrong. Regulators would never raid a value manager that happened to choose a tech stock, or a momentum manager that accidentally had a few stocks that did not move with the market. It is ridiculous to rate a company based on ESG as an input," he added. 

 

[Editor’s note: This article originally appeared on ETF Stream]

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