Passive funds don’t always come off well in ESG discussions. Trackers with an ESG remit sometimes nevertheless hold companies in environmentally harmful sectors, while passive providers more broadly stand accused of not engaging with businesses that should embrace better behaviours. That’s something we’ve covered in the past, including Chris Akers’ feature from the end of last year.
If such failings are widely discussed, it’s always interesting to see them quantified in a new way. A paper recently published by Common Wealth, a think tank, does exactly that. The authors Analysis of “The passive revolution” finds that, when it comes to UK-listed companies, passive funds are now “uniquely overrepresented” in their ownership of the oil and gas industry. Passives account for more than 40 per cent of fund ownership in the fossil fuel space (defined as oil, gas and coal extraction and related operations), making it the only major sector where that figure is so high.
As the authors explain, this emphasises the direction of travel from recent years. “While the combined 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 fossil fuel sector in the past three years, while the passive segment has continued to expand its stake,” they explain. As they put it, this backs the idea that passives could become "holders of last resort" for a very controversial sector.
With active funds increasingly forced to acknowledge ESG, passive funds taking on further assets – and even some ESG-oriented passives having limits on what they can exclude from portfolios (some hold the “best” companies from sectors such as energy, for example), these trends might seem unsurprising. But what’s interesting is how this complicates the argument that oil and gas businesses will simply be snapped up by private equity once other investors have driven prices down by divesting. Perhaps a wave of passive money will slow down that process if it does occur. Common Wealth’s paper notes that “the backward-looking nature of mainstream index construction could mean passive investments remain exposed to these firms, helping to maintain their share value, while other actors increasingly divest from them”.
But while mainstream passives are destined to follow markets, those markets can change. The paper acknowledges this argument too, noting that no pure-play coal mining company is currently in the FTSE All-Share, whereas such firms did have a presence just a decade ago. It should also be added that passive providers have claimed to be making improvements when it comes to engaging with companies and not all active managers have a perfect record here either.
Ultimately, the paper offers food for thought for investors of all stripes, whether they are weighing up ESG considerations or eyeing indices such as the FTSE All-Share as a play on a given sector. It's another reason not to think excluding “bad” companies from active ESG funds is a quick solution to the world’s problems. As ever, things aren’t quite black and white.
