Active vs. Passive ESG Investing
Which is the Best For You?
This is part three in a three part series.
Today we'll focus on Active vs. Passive investing, specific to ESG investing.
Parts 1 & 2 focused on:
We'll talk about:
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A brief evolution of investing advice (includes the main point)
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The Social Impact of active & passive ESG investments
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Which is right for you?
A brief evolution of investing advice
Passive investments are now the largest holders of investment assets. But it wasn't always this way.
Let's look at a brief history of investment advice to understand this evolution and why it is important to ESG investing.
What was recommended
Individual Stocks
Actively Managed Mutual Funds
Passively Managed Index Funds or ETF's
Back in the day
Today
Why was it recommended
Because they were the only option.
Because they allowed more diversification.
Because data showed that markets are efficient and it's difficult to "beat" the market net of fees.
To explain a bit more in depth:
Way way back in the day, an advisor may have recommended for you to buy the Dutch East India Company.
Because, well.. It was the only option in the 17th century. (Nerd point - this was the first company in history to be listed on a publicly traded stock exchange.)
Then in 1924 came the Massachusetts Investors Trust. The first modern day mutual fund.
Over time the popularity of mutual funds grew because they offered the typical investor:
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A diverse basket of stocks
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A professional manager to buy and sell these stocks on their behalf
In 1976 the first publicly traded index fund arrived, the Vanguard First Index Investment Trust by Jack Bogle.
The index funds success came from the Efficient Market Hypothesis.
This is the hypothesis that "the share prices reflect all information and consistent alpha (outperformance) generation is impossible." And, "stocks always trade at their fair value on exchange." 1
To put it another way...
You & I (and every other investor on the planet) have the same access to the same public information about publicly traded stocks. Therefore it is nearly impossible to "outsmart" all of the other investors and consistently beat the market over time.
If you're still reading that's great because what I'm about to say next is the whole point of this article..
The Efficient Market Hypothesis does not (completely) apply to ESG Investments!
For an efficient market to work properly, data needs to be widely available and standardized.
However, ESG data is not yet standardized.
For example:
In 2018 three well-known and highly regarded services came up with completely different ratings for Tesla Inc. on ESG issues. 2
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FTSE Russell rated Tesla as the worst carmaker globally based on its metrics
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MSCI Inc. ranked it the best
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Sustainalytics rated Tesla roughly in the middle
Because this ESG data is not standardized, and because research indicates that analysis of ESG data can provide value to a portfolio, it is still possible for an investor to "outsmart" the market.
This shows that an active manager has an advantage (possibly) at picking stocks that could outperform the index.
We're not yet ready to move past here!
What was recommended
Individual Stocks
Actively Managed Mutual Funds
Passively Managed Index Funds or ETF's
Back in the day
Today
Why was it recommended
Because they were the only option.
Because they allowed more diversification.
Because data showed that markets are efficient and it's difficult to "beat" the market net of fees.
I've been a financial planner since 2007. Through 13+ years of research, I am whole heartedly a believer that low cost passive investments outperform (over time) higher cost active investments.
However, I don't believe this applies to ESG investments. While I still believe costs are a key factor, I don't believe they should be our main screening tool when it comes to ESG investments.
Check out my "ah ha" moment in the article "What you need to know about fees and your ESG investments."
The social impact of Active & Passive ESG investments
As investors, we want to make a financial return.
As ESG investors, we also want to make a social return.
I am going to make an argument that actively managed ESG investments have the advantage here as well.
Here are a few reasons...
1) Active owners tend to have a better opportunity to engage management in the companies they own.
An important part of sustainable investing is active engagement with investee companies with the aim of encouraging and persuading companies to improve their ESG practices.
Passive ESG investments tend to own a larger chunk of the market (more companies) meaning the level of engagement they can have with each company is more limited compared to an actively managed fund which may own less companies.
Passive ESG management may not have the option to divest (sell their position in a company) because they may be obliged to replicate the index. Actively managed funds are generally less constrained
2) Passive investing tends to be historical focused whereas Active can be more forward focused.
Passive funds tend to either replicate an index, or use an algorithm to build their portfolio while an actively managed fund can choose to invest into companies that are improving their ESG metrics.
They can more easily identify companies who are transitioning towards more sustainable business practices.
So if your goal is to support companies who are actively trying to improve themselves, and thus society, you may do a better job with an actively managed investment.
3) Active funds tend to have more ability to engage in active ownership and shareholder activism
The documentary Lever provides a real life example of the impact that can be attained through active ownership.
Which is right for you?
I want to start by saying that I don't think there is any right (or wrong) answer.
I've learned in 13+ years of being a financial planner that:
Retirement planning is ultimately a bunch of educated guesses about what we’re doing currently, rolled together with a bunch of educated guesses about what we’ll be doing 30 years from now.
Meaning, there is a "margin of error" that allows for imperfect decisions.
I believe our general financial behaviors have more effect on our financial future than our smaller decisions.
If you are very fee focused and get stuck on the minutia of the numbers, passive ESG investing is probably your best bet.
If you believe that a manager could better sort through the ESG data and/or you believe that an active fund may have more social impact, active ESG investing is probably your best bet.
If you want the best of both worlds, you could use a mix of active & passive based on each asset class.
This Morningstar study3 breaks down a potential ESG advantage (actively managed advantage) based on geographic area of investment.
An imperfect decision you take action on is better than a perfect decision with no action.
If you don't know where to get started, I would encourage you to check out our Ultimate Guide to ESG Investments.
If you're on the fence about ESG investing, check out Five Reasons Why you should consider Sustainable Investing.
If you want tools so you can do your own investment research, check out these tools.
If you prefer to delegate, feel free to schedule a phone call. We're happy to help...
We're a different kind of financial firm than you may be used to.