Passive investing by proxy
26 August, 2016
There have been two enormous trends in share market investing over the last decade and their popularity has led to some interesting and unintended consequences.
Passive or index investing is one. It stands well apart from the other one — ethical investing or putting one's money into what one believes in.
Passive investing involves buying a fund that mimics a particular market. It is the opposite of active investing, which attempts to beat the market return by picking the winners and avoiding the losers in that market.
The popularity of index funds is unquestionable. They now account for more than 30 per cent of all stock and bond funds under management in the US, according to Morningstar.
The logic of investing in index funds seems simple and compelling. For long periods of time, most active funds have failed to beat the market ... so why bother trying? Actively managed funds cost more than passive funds — because someone needs to be paid for researching the winners and losers. Fees matter in the long term, so best stick to the cheapest.
Ethical or socially responsible investing is a popular idea for different reasons. Why not invest in companies and industries consistent with your personal beliefs and values?
Ethical investing can be achieved positively — directing funds into industries that meet one's ethical guidelines — or negatively, by eliminating certain industries altogether, such as gambling, tobacco and alcohol.
Investing with a clear conscience is easy today, with most fund management firms either offering socially responsible fund options or at least disclosing their ethical investing framework so investors can make an informed decision. Investors can choose funds that avoid investments in armaments, tobacco, alcohol, fossil fuels and other "sin industries".
Or can they?
The intersection of ethical investing and passive investing is where things get interesting.
Increasingly, large fund managers have chosen to use index funds for management of their clients' savings. Fund managers can aim for the best of all worlds by combining passive funds with some active management to give their clients diversified, less volatile and cost-effective investment offerings.
It is now common to hear names like Vanguard, iShares and Charles Schwab included in fund manager line-ups.
The problem is, an index fund doesn't choose its investments — it will own good companies and bad, in sin industries and not. The companies in an index are determined by their size, not by their goodness.
As more money has flowed into index funds, big companies have grown bigger and certain industries have become over-represented in market indexes. Some that have benefited from growing index fund popularity are the sin sectors — tobacco and armaments being two notable culprits.
As fund managers have embraced index funds, they have unwittingly invested more of their clients' savings in industries and businesses that, elsewhere in their business, they have actively sought to avoid.
Passive funds are not only passive in selecting stocks but also in their treatment of companies they invest in. They don't visit management, lobby companies or vote to change practices to encourage "good corporate citizenship". They don't do anything to further the ethical expectations clients of most fund management firms have nowadays.
Perhaps it is unrealistic to expect these two significant investing trends to be complementary. You can't be passionate and passive at the same time.
It will be interesting to see which of the two proves more important to investors over time.