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Why passive investing and sustainability are incompatible

Why passive investing and sustainability are incompatible

Passive investing and sustainability integration have very different investment philosophies, and therefore are difficult to unite.

David Blitz, head of quant research at Robeco, said as sustainability and passive investing are fundamentally irreconcilable, investors must choose one or the other.

The idea behind passive investing is that active management is a zero-sum game before costs.

By passively following the capitalization-weighted market portfolio, passive investing generally is expected to achieve above-average performance through minimal costs.

In theory, there are a few ways passive investors could integrate sustainability considerations into their investment strategies.

One example is active voting and engagement, which is possible for passive owners of shares.

In reality, however, it does not matter much if passive investors vote or engage, as the business model of passive managers is to replicate the market index as closely as possible.  

Moreover, there is very little that passive investors can do if firms do not take their engagement efforts seriously, apart from threatening firms with bad publicity.

Notably, passive investors cannot actually sell their positions in firms that only pay lip service to ESG issues as they are obliged to replicate the entire market portfolio.

Meanwhile, passive investors could also exclude stocks that are most problematic from a sustainability perspective, or choose to passively follow an environmental, social and governance (ESG) index, to integrate sustainability considerations.

However, comprehensive sustainability integration involves many active decisions and requires active portfolio management, risk management and performance evaluations.

As a result, investors find themselves in the active management space, whether they like it or not.

Blitz said one alternative solution is to take an active sustainable approach that stays close to the passive market index.

It is still possible to achieve a portfolio with a strong sustainability profile, even when individual stock weight are not allowed to deviate much from the capitalisation-weighted index, he said.

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