Kames Capital: ‘Biased’ ethical passives missing out on wealth of opportunities

Ethical and sustainable investors using passive strategies are missing out on a wealth of opportunities overlooked by the rules-based investment products, Kames Capital’s Ryan Smith has said.
While ethical and sustainability-related trackers have grown in popularity in recent years, Smith believes there are a number of inherent risks to the performance of such products over the long term because of the way they allocate capital.
Smith, head of ESG research at Kames, said many trackers end up with overweight in large cap companies because those stocks put out the most disclosures when it comes to their sustainable practices. Smith adds that purely measuring company disclosure does not always translate into a more ethical or sustainable business.
“Focusing predominantly on those companies that make good environmental, social, and governance (ESG) disclosures can result in a bias towards certain sectors, while overlooking the genuinely good opportunities,” Smith said.
“Such indices typically invest most of their assets in large-cap companies, but this goes against our experience when managing both our ethical and sustainability funds, where both approaches have a bias to small and mid-cap size companies.
As well as creating a tilt towards large cap names, Smith said trackers also have geographical biases which can leave investors over-exposed to established names, and underweight businesses at the cutting edge of sustainable industries.
“The indices are typically populated by European stocks, with little in emerging markets, but many of the most material sustainability challenges are occurring in Asia,” Smith said.
“Therefore, investors avoiding this region are missing out on the opportunity to provide capital to the businesses providing solutions to these issues.”
Smith added recent studies into responsible investing support the notion that the best way to add alpha is to focus on companies making broad improvements to their environmental, social and corporate (ESG) performance, rather than just by owning the established ESG leaders. “This is why the Kames Global Sustainable Equity Fund invests in sustainable companies of various sizes, stages of development and across geographies,” Smith said.