The ultimate sanction any investor has if they are unhappy is to sell the asset.
An investor may choose to sell as a result of feeling that the financial case for an investment is no longer valid; an investor with an ESG focus will also consider whether an investment continues to meet the sustainability criteria of their mandate.
By definition, index investors do not have this power, as they must own all of the stocks within its index, in proportion to each equity within the index.
Nicolo Bragazza, investment analyst at Morningstar, says: “Stewardship when it comes to index funds is more problematic than active funds and this is not because they do not have the possibility to do so, but more importantly because they have to track indices usually provided by third parties.
"Active managers have the ability to decide which company they want to buy at their full discretion and usually they know in advance the areas or topics where engagement has the potential to deliver better outcomes.
"More importantly, active managers may exit their investment if the company does not meet their recommendations. On the other side, passive funds do not have such flexibility in their investment decisions and so, this represents an important limitation as they cannot divest their investments.
In this manner, they may be less effective in their engagement effort.
This inability to sell an unsuitable stock does not, however, hamper the ability of ESG investors to engage in stewardship, according to David Barron, head of Index Equity and Smart Beta at Legal and General Investment Management.
He says that companies which do not engage meaningfully with ESG issues will be excluded from indices, and as more cash gets placed into the funds which are created to track those indices, the outcome will be share price underperformance relative to those stocks which do pay attention to ESG considerations.
He says that because product providers respond to investor demand, the indices which are created in future will be those that include companies that behave best on the issues that matter to clients.
Mr Barron says that as companies which are not engaging with ESG are left out of indices, the share prices of those companies would likely fall, as they would be excluded from ESG portfolios.
Richard Whitaker, vice president, BlackRock Investment Stewardship, at BlackRock says: “Index investors are long-term investors; we use three tools at our disposal: thought leadership, engagement and voting.
"We have a large global team with regional presence speaking 17 languages, working in this area. We think this level of resource and expertise helps us promote our clients’ long-term interests.
