Our typical reader is already way ahead of me on this: going ESG means, by definition, you're not passive and, by definition, going passive means you're not ESG. It's a tautology; it is what it is.
In June 2017 Matt Levine at Bloomberg View had some related thoughts on index construction and the Governance part of ESG that I've been meaning to post but first, just so our position is clear, we have not seen any academic research that overturns the findings of the Marcin Kacperczyk (now Imperial College London) and Harrison Hong (now Columbia) paper "The price of sin: The effects of social norms on markets" which we headlined way back in 2007 as:
Moral Judgment On 'Sin Stocks' Means Higher Returns For Vice-Friendly Investors
Until ESG can be shown to, at minimum, equal broader indexes over time (not just for a quarter or a year as sometimes happens) our chosen approach is to pursue the vice afforded by broader exposure and use the excess returns for whatever do-gooder projects strike one's fancy.
It's a variation on John Wesley's Sermon 50, The Use of Money (1744) which contains the admonition:
"Earn all you can, Save all you can, Give all you can"
So, with Wesley thundering in our ears, here's part of Mr. Levine's June 20, 2017 Money Stuff piece "Bank Relationships and Index Rules Also Bancor, leaky brokers, Martin Shkreli, slot machines and unicorns.":
...Indexing.
Is Facebook Inc. a company? Hmm:
A proposal being floated by a large index firm could force finance chiefs at companies like Alphabet Inc., Facebook Inc. and Ford Motor Co. to choose between keeping their places in broad stock benchmarks or changing their share class structures.Let's say you want to invest in the entire U.S. stock market. The Russell 3000 index, which covers about 98 percent of the U.S. public stock market, is a reasonable proxy for that. So you might buy a Russell 3000 index fund.
FTSE Russell is proposing possible restrictions on the inclusion of companies with unequal voting rights in its indexes, but the firm will weigh input from clients and investors before working out specifics.
But let's say you also think that Good Governance Is Good, and that dual-class shares are bad. Then you might ... well, you might do a lot of things. One thing you could do is buy the Matt 2997 index fund that I just made up, which buys all of the stocks in the Russell 3000 except Alphabet, Facebook and Ford. Or if you are a big institutional investor you can replicate that yourself: Just look at a list of the Russell 3000 stocks, observe which ones have dual-class shares, and buy the rest of them.
Then one of three things will happen:
Any of those things would be fine, really! This is life, and investing: You make choices, and sometimes your choices work out well, and sometimes they don't. But of course the passive-investing revolution is about not making choices, so making this choice is awkward. You can't just buy 2997 of the Russell 3000 stocks, especially if the omissions are as big as Alphabet and Facebook. That would be active management, and your belief that Active Management Is Bad is even stronger than your belief that Good Governance Is Good.
- You will outperform the index, because Good Governance Is Good and leads to better performance; or
- You will underperform the index, because Good Governance Is Good Only On Some Longer Timeframe or whatever, but you will feel good about striking a blow for good governance.
- You will underperform the index, conclude that Good Governance Is Bad, and go back to buying Facebook stock.
So the trick is to get FTSE Russell to make the choice for you: If the Russell 3000 doesn't contain dual-class stocks, then you can just buy the index, avoid those stocks, and neither outperform nor underperform the index. This is purely cosmetic: Facebook and Alphabet still exist, and if you invest in the Neo-Russell 3000 and they outperform it, then you have still missed out on performance by not buying their shares. But it is performance that you don't care about, because your performance is measured against the index, not against the actual universe of all investable stocks. So you're fine, as long as FTSE Russell makes the decision that you want it to make.
"'The future of the markets are at stake,' said James Andrus, an investment manager at the California Public Employees’ Retirement System," and it's an extraordinarily silly thing to say. He works for Calpers! They have a lot of money! They can just buy the stocks that they think are good and not buy the stocks that they think are bad! They don't have to outsource that decision to FTSE Russell, and then lobby FTSE Russell desperately to make the decision they want! They can just make the decision they want! But they can't, because that would be Active.
Elsewhere, "MSCI will decide on Tuesday whether to include Chinese domestic stocks in the benchmark emerging markets index":
Investors in mutual- and exchange-traded funds tracking indexes often think they’re making a simple decision to follow what the market’s doing. In reality the indexes have mutated from measures of the market into primitive investing algorithms, with sometimes odd effects.....
