Can Engine No. 1 help Wall Street overcome finance inactivism?

Reprinted from GreenFin Weekly, a free newsletter. Subscribe here.

A few weeks ago, I asked: Are passive index funds sustainable?

Many thanks to all of you who shared your take on this question with me at [email protected]. I’d like to provide an answer to the question of whether the enormous and passively managed pool of capital in indexed investments can support the transition to a clean and just economy. Or, at least, the start to one.

The simplest phrase to capture the GreenFin community’s responses here would be “yes, and.”

The financial sector certainly has its share of inactivists among its ranks, dare I say even some who affix the SDG pin to their lapel. The climate scientist and author Michael Mann’s term is meant for those who aim not to convince anyone that the climate challenge isn’t an existential one, but rather to soften enthusiasm to address it head on.

Fund managers and indexers have continued to get away with incremental progress on climate and ESG issues.

Therein lies the immorality inherent in finance’s inactivism. When it comes to indexed investment products, fund managers and indexers have continued to get away with incremental progress on climate and ESG issues by limiting coverage of their climate targets to their actively managed portfolios, then throwing their hands up when the same is asked of their passive, index-tracking funds.

Engine of change

So, what are some viable pathways to getting the ever-growing world of indexed financial products to more seriously support the sustainability imperative? Simply put, there’s continuing the passive approach, albeit with some tweaks, or embracing a more active stance.

Passive-Active: The current ESG epoch, dubbed ESG 2.0, is largely defined by organizations embracing ESG because they recognize the bottom-line benefits of incorporating sustainability into their corporate strategies.

For asset managers, this often takes shape via substantive engagement with the portfolio companies in which they invest, beyond the “ESG 1.0” decision-making about which firms and sectors to invest in, exclude outright or divest from.

When it comes to the Big Three asset managers — BlackRock, State Street and Vanguard –– which nine in 10 companies in the S&P 500 have as their single largest shareholder, this “passive” ownership through indexed products has had a notable feature: proxy voting policies that default to siding with management on ESG issues.

A decision not to act, one that can have deleterious outcomes for the real economy and for real people, is hardly passive, no?

Well, the folks at Engine No. 1, who seem to share many of the criticisms of passive ESG investing, came to the idea for an indexed product that seeks to tackle this inertia.

Active-Passive: Michael O’Leary, managing director at Engine No. 1, responded to my previous piece with the guiding principle that ESG investors should be defined not by what they hold, but by what they do.

The San Francisco-based activist investor that, for the bargain price of $12.5 million, won three board seats at ExxonMobil, last year launched a passive indexed fund (Transform 500 ETF) that aims to make clear how moving into ESG funds can have real impact. That’s a case the space could use right now, as biting ESG critiques keep coming.

If you’re familiar with Nobel Laureate Richard Thaler and Harvard Law School Professor Cass Sunstein’s book “Nudge,” you may recall the power of the “choice architecture” that surrounds us. As the status quo bias asserts, people are likely to continue a course of action since it has traditionally been the one pursued, even if it may clearly not be in their best interest.

Engine No. 1 is seeking to flip the institutionalized inertia of siding with management on ESG issues by setting a policy that supports a vast majority of climate and ESG proposals on the proxy ballot, and “by being a 100 percent purpose built firm,” O’Leary told me.

Transform 500 ETF merely “holds the largest 500 U.S. public equities — no exclusions, no re-weightings on ESG factors or otherwise,” O’Leary said. “It’s a passive index fund, but we use our ownership in those companies to drive positive impact –– and long-term value –– through how we vote our shares and engage with those companies.”

If the success at Exxon is itself a proxy for the power of deep engagement with a company and its sympathetic shareholders, then what will success look like for this type of active approach to passive funds?

It’s not a short-term exercise, which makes it a rarity on Wall Street. Taking a principles-level view, the Exxon win begins with appointing new decision-makers aiming to redirect the course of consequences from decisions made over past decades. The opportunity at Exxon is about the changes to be made in the 10- to 15-year horizon, starting with, for example, the oil giant’s first net-zero commitment.

I’ll be keeping a close eye on the 2022 proxy season to see how a passive –– but actively engaged –– index fund like Engine No. 1’s can put its money where its mouth is, and to what effect, for both its investors and the planet.