Advisors who want to deliver client-centered environmental, social and governance (ESG) to investors “inherently” need to use active management, according to a new white paper from the Investment Adviser Association’s Active Managers Council (AMC).

“The traditional fully-active approach allows for a more nuanced consideration of quantitative and qualitative factors, which helps investors tailor their portfolios to their sustainability goals,” AMC says in the paper, “Sustainable Investing is an Active Process.”

In fact, active sustainable funds stand out as one fund industry category generating notable positive net inflows—$10.8 billion last year, compared to passive funds, which attracted $11.1 billion in 2019, according to Morningstar Direct.

Passive funds tend to use the flavors offered by MSCI’s ESG indexes and rely heavily on ESG ratings from providers such as Facebook, Apple, and the Google unit of Alphabet, which rate megacap companies higher because smaller companies lack the resources to create the reams of disclosures rating companies require. That leaves quality, sustainable companies out of indices and ripe for active manager picking.

Active manager funds fared better in the growth, value, small-cap, and non-U.S. categories, and Morningstar expects active managers as a group to continue to improve their use of ESG factors, with funds like Parnassus Core Equity (PRBLX), Brown Advisory Sustainable Growth (BIAWX), and Calvert Equity (CSIEX) standing out because of their concentrated approach.
“The reality is that passive management is a very blunt instrument when it comes to ESG. They can do a lot of top down analysis, but it is very difficult for them to engage with the 2,000 companies that make up their indices. We have teams of analysts that do that all day. As a result, we believe that active ESG management is the best way for advisors to future-proof their fiduciary responsibility to their clients,” said Vish Hindocha, director of investment solutions for MFS, told Financial Advisor magazine. Hindocha is a member of the AMC.

The AMC’s white paper asserts that sustainability ratings are just a starting point for advisors who want to select an ESG approach that is integrated with investor goals.

“Perhaps the most compelling evidence for the subjective nature of the process is the dispersion of the sustainability ratings used in the index-based approach,” according to the paper. “If the ratings process was 100% objective, all of the ratings systems should generate similar scores for the same companies. However, those scores can differ significantly."

The ratings on automaker General Motors are a case in point. In May 2020, ratings provider JUST Capital ranked GM as number one in the "automobile and parts" industry and within the top 2% of all 922 companies that it rates.

By contrast, ratings provider MSCI scored GM as a “laggard” in its industry, with the lowest grade of CCC.

“There are benefits to active management with ESG that you won’t find in index-based funds,” said Todd Rosenbluth, director of ETF and mutual fund research at CFRA, an independent research firm. “Active managers usually have a broad team of analysts that look at specifics and metrics. Index funds focus on companies that meet their ESG criteria, which can be broadly diversified or more narrowly focused strategies."

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