Passive Funds Take Active Role in ESG

Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall, and here with me today is Morningstar's Jose Garcia Zarate to talk about governance.

Hi, Jose.

Jose Garcia Zarate: Hello.

Wall: So, I think, there is a conception, maybe it's a misconception, that it is only active asset managers that care about ESG issues, in particularly, governance, because passive fund providers are measured by the entire of a particular index, therefore ESG is just not part of their consideration. Is that true?

Zarate: Well, that is actually the misconception. And the fact is that because passive investing is growing so rapidly across the world there has been a lot of press noise particularly saying, well, basically, how do we know that these passive managers care about the companies, the governance and how these companies are run, because at the end of the day they have to buy all the companies that are in an index. So, do they really care about how the companies are run? And so, we decided to run a study, a survey. We are not particularly experts in the corporate governance area, but we felt it would be a good opportunity to either prove or disprove the misconception.

Wall: And I think it is very important, because as you highlight passive fund providers are increasingly taking share in these companies. I mean, iShares alone is one of the largest providers of these types of funds.

Zarate: Indeed.

Wall: And so, what were the key findings from the survey?

Zarate: Well, what we found actually is that they take it very seriously. Most of the providers that we surveyed--and we surveyed 12 providers of passive funds in total, in the United States, in Europe, the two in Japan. The fact is that it's very rare to find a pure passive fund provider. So, for example, you alluded to iShares, or Vanguard, they do both active and passive. And the fact is that when it comes to corporate governance and actually overseeing the companies that they invest in, they apply exactly the same principles irrespective of whether the stock is in a passive fund or an active fund. So, that was a bit encouraging in a way.

We also found out that there have been significant increasing resources dedicated to the corporate governance teams in these companies. And I think that's actually quite encouraging for investors that might be concerned that, I'm investing in a passive fund but basically the manager doesn't really care about how the companies are run. At the end of the day, these companies, or the passive funds, are the ultimate long-term investors. They cannot sell the company as long as it is in the index. So, they have got a vested interest actually in making sure that the company is well run.

Wall: So, overwhelmingly positive, but there must have been some disparities between the providers or at least in the answers that were given by the providers. What were the key differences that you found?

Zarate: I think most of the key differences basically are related to the scale of the operations. So, obviously, for the biggest fund providers it is easier, let's put it that way, to devote the financial resources to increase their corporate governance teams to engage with the companies that they are investing in, because this actually represents a financial cost and that financial cost sooner or later could actually be paid by the investors. So, there are differences in the scale of the programs. But overall, we were positively encouraged by the efforts.

Wall: And what about the direction in which they are moving? I presume given the positive feedback you've given so far this is something that is increasingly important to these providers.

Zarate: I think it is becoming increasingly important because as I mentioned earlier on, I think they are getting a lot of negative press and media coverage because there is hardly any understanding of what they do. And actually, one of our recommended best practices goes to the issue of disclosure and education. I think it is important for passive fund providers to let people know that they are doing this and how they do it and provide as much information as possible.

Wall: Jose, thank you very much.

Zarate: You're welcome.

Wall: This is Emma Wall for Morningstar. Thank you for watching.