In the third quarter of 2022, nearly 96% of the money invested in sustainable funds in Europe went into passive strategies.
But what’s causing these tremendous flows into sustainable tracker funds, and can index funds benefit the environment and society?
We take a closer look and share two tracker fund case studies that integrate ESG considerations.
This article isn’t personal advice. If you're not sure if an investment is right for you, ask for financial advice. All investments can rise and fall in value, so you could get back less than you invest.
Active vs passive funds
Index (tracker) funds have proven extremely popular in recent years, and it's easy to see why. They're a simple, low-cost way to invest in shares and bonds. Unlike an active fund, they don’t try to beat the performance of the broader market. Instead, they aim to track its performance over the long term.
Traditionally, responsible investment solely resided in the active fund management camp. This involved managers either selecting companies that were doing good for society or met certain environmental, social and governance (ESG) criteria.
These funds would also often apply exclusionary screens to sectors perceived to have a significant negative impact, like gambling and tobacco.
But the passive index space has come a long way in recent years. There are now a huge number of passive funds that integrate ESG considerations.
They can do this by tracking a screened index, like the FTSE4 Good, or tracking an index that hasn’t been screened, like the FTSE All-Share, and investing in all of the companies in that index that meet their criteria.
Alternatively, they could invest in all of the companies in an index, but adjust the size of their investments depending on how well each company scores against a set of ESG criteria.
Can index investing make a positive difference to society and the environment?
Responsible tracker funds take a variety of different approaches, so the positive difference they make to the environment and society can vary wildly.
Most responsible tracker funds tend to exclude companies generally perceived to have a significant negative effect on the world. This means money is diverted away from the most harmful pockets of the economy.
The impact can be even greater if, on top of criteria-based exclusions, the fund has the flexibility to invest more in companies that score well on ESG metrics, and less in those that don’t.
The advantage of investing less in poorly-scoring companies, rather than selling their shares completely, is that the investment team can engage with them to help improve. Investing more in exchange for improvement on various factors is a good incentive, so investors' money makes a positive difference.
But that’s not the only good responsible tracker funds can do.
Lots have large stakes in the companies they invest in. This means the managers of those funds get a say on a range of issues – from strategy and operational performance, to risk management and corporate culture.
They can also influence companies to adopt better ESG practices. This engagement has the potential to positively benefit the customers, employees, and shareholders of the companies they invest in.
If companies fail to make the required progress, the fund manager might choose to vote against the management team at the company’s next annual general meeting (AGM).
Here are two examples of sustainable tracker funds that integrate ESG considerations.
Remember, investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a long-term diversified portfolio.
As with any index tracker fund, things like withholdings taxes, dealing commissions and spreads, and the cost of running the fund all drag on performance. To try and follow the index as closely as possible, the funds we refer to below can use derivatives. The use of derivatives adds risk.
For more details on each fund and its risks, see the links to their factsheets and key investor information below.
Vanguard ESG Developed World All Cap Equity Index
This fund takes a relatively simple approach. It aims to track the performance of the FTSE Developed All Cap Choice Index.
The index excludes companies based on the impact they have on society and the environment, like those involved in alcohol, gambling, tobacco, fossil fuel production and weapons. It also avoids companies that have been embroiled in severe controversies.
The managers engage with the companies they invest in to push for positive change. But they don’t have the option to sell the company’s shares if it doesn’t meet expectations.
Find out more about Vanguard ESG Developed World All Cap Equity Index including charges
Vanguard ESG Developed World All Cap Equity Index key investor information
Legal & General Future World ESG Developed Index
This fund aims to track the performance of the Solactive L&G ESG Developed Markets Index and invests in the same companies as the index.
The index increases investments in companies that score well on a variety of ESG criteria – from the level of carbon emissions generated, to the number of women on the board and the quality of disclosure on executive pay. It also reduces how much is invested in companies that score poorly on these measures.
The fund won't invest in persistent violators of the UN Global Compact Principles (a UN pact on human rights, labour, the environment and anti-corruption). It also avoids companies involved in tobacco, controversial weapons (like cluster munitions, anti-personnel mines and chemical and biological weapons) or civilian firearms.
The fund also won’t invest in companies that earn more than 20% of their revenues from thermal coal and oil sands.
The fund is managed to achieve at least a 7% reduction in carbon emissions per year until 2050. The aim is to align the fund with the Paris Agreement, which aims to limit the temperature rise caused by global emissions to 1.5°C above pre-industrial times.
Find out more about Legal & General Future World ESG Developed Index including charges
Legal & General Future World ESG Developed Index key investor information