Shoutout to our go-getter reader Caleb for asking this thoughtful question that many others are probably also wondering about. Can passive index investing work when trying to be socially responsible or does an investor need to find an actively managed fund to have any real impact? He noticed that the socially responsible version of the index fund he was invested in was not all that different from the original index fund. As a result, he was wondering if it’s even possible to make a real positive impact through passive investing.
TLDR: a sustainable index fund is better than not considering sustainability at all. However, actively managed sustainable funds have the potential to create real and lasting change.
Let’s start by quickly going over what passive and active investing strategies are.
Passive investing “broadly refers to a buy-and-hold portfolio strategy for long-term investment horizons, with minimal trading in the market” and has been on the rise in recent years largely due to its low fees. Investing in index funds is the most common form of passive investing and involves trying to match market returns by tracking a financial market index such as the S&P 500.
Active investing is an investment strategy wherein a fund manager makes specific investments with the goal of outperforming the market. It typically has higher fees than investing passively due to the amount of work that goes into researching and actively buying and selling, hence “active” investing.
If you’ve read anything about how to DIY investing, you’ve probably heard that you should invest in index funds. While this may be a good recommendation if you choose to forgo working with an expert to manage your money, there are downsides to this approach, the main one concerning social impact.
These days, there are many ESG (environmental, social, governance) index funds available to investors. These passive funds that strive to be socially responsible are frequently very limited in what they can accomplish. They usually rely heavily on ESG ratings from third-party data providers and screen out companies that don’t meet certain criteria. They are heavily dependent on self-reported data. On the other hand, actively managed ESG funds have many more tools at their disposal. In addition to using ESG data to screen companies, these actively managed funds have the power to divest and to engage with companies through proxy voting, shareholder resolutions, and actively working with companies themselves to nudge them towards making more socially conscious decisions. You can read more on how we at Good Capital create change using our investments here.
Some of you may be thinking, I’ll have to sacrifice performance if I want to invest sustainably. Doing good and making money? It’s too good to be true! HOWEVER, there is more and more research pointing to “ESG funds consistently do just as well, if not sometimes a little bit better, depending on the timeframe, than conventional funds.” You can read more about this debunked myth here!