Passive investing for sustainable investors and do such products work?

Passive investing has a Jekyll and Hyde reputation amongst the investment community.

 Ethical riches from rags

On one hand, people like the fact that cheap market access has helped a lot of people to save and invest. In a world that was dominated by underperforming active managers for a long time, this is generally seen as a universal good. Not everyone can outperform the market and it is a mathematical certainty that most people will not, so receiving what the market achieves for a low fee has managed to democratise finance.

On the downside, a number of commentators have voiced concerns that this move into passives has in some way made markets more risky. As its name suggests, passive investing does very little to steer clear of any bumps in the road of the investment cycle – as a result, investors can enjoy the highest of highs, but similarly, the lowest of lows. As such, the detractors think that investors should be wary about relying on passive products.

But where sustainable investing is concerned, does passive investing provide the right ‘way in’ for investors?

ESG – passive or active?

Generally speaking, ESG investing is fairly complex and that complexity is probably – on the whole – more suited to active investment management. Sophisticated decisions on a company’s reputation, governance, environmental impact, means of production and product lines are probably best made by an individual or a team, as opposed to aligning an ESG portfolio to a particular index.

That said, passive investing for ESG does two similar things to an active model. Firstly, it excludes companies or sectors that are unarguably bad, like guns and tobacco, and makes a call on companies that are less obvious. The second thing it does is to try and allocate to the companies in the index with the most sustainable policies, procedures and product lines. The difference is how much human judgement is used, but the likelihood is that you will end up in a relatively similar place – you will not hold arms or tobacco, but you will hold consumer staples and other less controversial areas.

There is no question that active management is great for responsible investors, because there are very few obviously good or bad companies and human interpretation is useful. If this could be done in a methodical, competitively priced way, most investors would prefer this, but the truth is, there has not been enough of that on offer in active ESG investing. As a result, investors have voted with their feet and changed to cheaper, simpler index-led strategies. And who can blame them? It is essential that sustainable investors have access to low-cost products too.

Is ESG the next investment bubble?

After tulips, the dotcom boom and cryptocurrency, many are suggesting that the popularity in ESG is creating a ‘bubble’ in responsible companies. But where passive investing is concerned, the likelihood of all indices becoming ESG focused is just not going to happen, as human behaviour and incentives will dictate there are funds and companies around that will not be ESG focused and investors will want to profit from those too.

ESG is a movement that is probably here to stay and it will, in time, encourage more companies to behave and act in a responsible way and inspire others to change the planet in what they create and the way they do business. In a similar vein, passive investing – through its downward pressure on active fees – has opened up the world of investing to a lot more people. The upshot of this means that through passive ESG strategies, more retail investors will be drawn into ESG investing and will be putting their money towards more companies with sustainable or ethical business models. And that has to be a good thing, does it not?

There is no doubt that passive strategies are enabling more people to get into investing and as a result, more investors with an ethical persuasion can get in on the game too. But in reality, a lot of the decisions around ESG investing are highly nuanced and the passive model, does not quite allow for that at the moment. So while passive investing can satisfy investors’ ethics to a degree, it will not be suitable for investors who want to change the world just yet. But as both the passive industry and ESG investing evolve, who is to say what is around the corner? Together, they just might become the force for good the world of investing needs.

Patrick Thomas is an ESG investment expert at Canaccord Genuity Wealth Management 

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