Exchange-traded funds (ETFs) and passive products are "not the right tool" to achieve both financial and positive impact return, according to Fred Kooij (pictured), chief investment officer at Tribe Impact Capital.
With 45% of actively managed UK equity funds underperforming the S&P UK BMI benchmark year to date, according to a recent Spiva report, it is difficult to pick the right active managers and justify their fees, Kooij said, making it "understandable" that retail investors turn to ETFs.
However, the CIO detailed key factors which investors seeking effective ESG and impact portfolios need to consider before relying on passive products, including "blind index tracking".
Passive managers are either choosing to ignore the data in the marketplace or they are not weighting it enough within their rules and the algorithms."
"As it currently stands, passive strategies typically replicate an index without explicit engagement or stewardship on the companies within the index," he said.
"This can leave passive strategies exposed to holdings at risk of poor ESG outcomes with limited opportunities to engage directly with all companies in the portfolio."
ETFs labelled as 'impact', 'responsible' or 'sustainable' may also rely solely on third party ESG data, Kooij added, which can leave passive funds holding more "businesses whose practices and products are not sustainable and positively impactful".
Additionally, there is "enough [company] disclosure" available to investors, Kooij said, which should provide enough information for passive products to achieve more with sustainability.
"It appears passive managers are either choosing to ignore the data in the marketplace or they are not weighting it enough within their rules and the algorithms."
These factors, combined with "limited shareholder engagement" can result in passive funds being "as much a part of the problem as their holdings", Kooij argued.
"Investing for impact cannot be silent on what a company does."
"In an actively managed approach, engagement and stewardship is more easily achieved on more concentrated portfolios; baked into bottom-up stock selection, and in the case of sustainable/impact active managers, the inclusion of explicit ESG/impact targets and outcomes."
However, the ETF industry has started to recognise these factors and instigate change, with specialists building proprietary indices "populated with companies that have been subject to rigorous analysis and engagement", before being wrapped into a cost-effective ETF, Kooij recognised.
He added that while positive steps are being taken, most underlying indices still update only half yearly and shareholder engagement needs "significant development" before these limitations can be overcome.
"Inputs into decision making today need to be multi-dimensional and based on finance, social, environmental, geopolitical and economic factors. Nuances in the data need to be appreciated as much as the data itself needs to be interrogated."
This article was first published by our sister title Investment Week
Fund houses commit to cut emissions by 2050