Interactive Investor

Fossil-fuel impact: does it blight passive funds?

29th April 2022 09:02

Faith Glasgow from interactive investor

Faith Glasgow considers whether passive funds are to blame for slowing down the transition to more sustainable energy sources.

As actively managed funds retreat from investment in fossil fuels in light of environmental, social and governance (ESG) concerns, a think tank has concluded that passive funds are expanding their holdings in the sector – and in the process slowing down the transition to more sustainable energy sources.

A report by think tank Common Wealth, looking at the growth in passive investing and its implications for corporate Britain, finds that the fossil fuel industry is the only area in which passive fund management groups now represent more than 40% of total fund ownership.

The report finds that “while the combined [fossil fuel] holdings of both segments have stagnated, there has been a clear compositional shift in this ownership toward passive funds, as the active segment appears to have begun a modest but clear retreat from the sector in the past three years, while the passive segment has continued to expand its stake.”

It points to this trend as supporting activistsconcerns that passive funds are “becoming ‘holders of last resort’ – extending the lives of fossil fuel firms by helping sustain a higher share price and lower cost of capital despite active market moves out of the sector.”

But Morningstar’s Jose Garcia Zarate, associate director of passive strategies, refutes that argument. He points out that passive funds by definition simply track the constituents of existing indices, so the fact that they still hold fossil fuel companies is a reflection of investor preference, not an indication that those funds are actively skewing their holdings.

“The passive industry, certainly in Europe - but I acknowledge, less so in the US – has gone to great lengths to offer investors the choice between passive funds tracking mainstream indexes that continue to include the likes of fossil fuel companies, and ESG benchmarks that exclude those holdings,” he says.

Certainly, a large share of European flows into passive funds now go into ESG alternatives as a direct consequence of investors actively choosing not to have exposure to fossil fuels. “But if investors in passive funds were to decide en masse to switch to ESG, then the assets in mainstream passive funds would shrink or even disappear altogether.”

If that were to happen, he suggests, then the passive fund managers - the likes of BlackRock, Vanguard and State Street – would likely be faced with the prospect of closing mainstream non-ESG funds, as theyd become financially untenable. 

Of course, investor choice could be manipulated. One option would be for the giant providers of passive funds simply to decide (or be compelled by policymakers) to switch all their funds to ESG benchmarks as a matter of principle, and shut the mainstream ones - a solution that the Common Wealth report would appear to support.

“They could certainly do that, but such a drastic business decision would surely need to be backed up by their investors,” argues Zarate, “and for all the positives about ESG, not all investors want to divest from fossil fuels at this stage.”  

On a rather different tack, Mark Northway, investment director of the passives-based investment manager Sparrows Capital, says the underlying Common Wealth argument that passive funds are deliberately supporting ‘sin stocks’ while active managers pull out, as “intuitively satisfying but inconsistent with the mathematical reality”.

Northway argues: “The concept of passives buying the elements of the market that active players dont want is nonsense – they will buy the percentage of each asset that it represents of the market or index.”

Instead, he says, passive managers effectively “delegate their thinking to the active market players”. So, for example, assuming a passive fund holds the whole global equity market index, what happens if active managers collectively reduce their exposure to a sin stock from 3% to 2%?

“That holding doesn’t ‘move’ from active into passive, because passive cannot hold more than the percentage that that stock represents in the global index,” explains Northway.

Instead, the dumping of shares by active managers will push the price downwards, reducing the company’s market capitalisation – and thereby also the percentage of the total index owned by passives, “without them having to do anything”.

Northway concludes that therefore “price-making is the domain of active participants, while the existence of passive holders actually increases the impact of decisions by active players”. As passive assets increase as a percentage of funds under management, so the ability of active participants to impact prices increases.

“Passive doesnt act as a hiding place for unwanted stocks and antisocial industries. In fact, it duplicates and amplifies the collective decisions of active participants,” he says.

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