When ideals clash with returns

There have been two enormous trends in share market investing over the past decade and their popularity has led to some interesting and unintended consequences.

Passive or “index” investing is one. It stands well apart from the other one — ethical investing, or putting one’s money into what one believes in.

Passive investing involves buying a fund that mimics a particular market. It is the opposite of active investing, which attempts to beat the market return by picking that market’s winners and avoiding its losers.

The popularity of index funds is unquestionable. They now account for more than 30 per cent of all stock and bond funds under management in the US, according to Morningstar.

The logic of investing in index funds seems simple and compelling. For long periods, most active funds have failed to beat the market . . . so why bother trying? Actively managed funds cost more than passive funds — because someone must be paid for researching the winners and losers. Fees matter in the long term, so best stick to the cheapest.

Ethical or socially responsible

You can’t be passionate and passive at the same time

size, not by their goodness.

As more money has flowed into index funds, big companies have grown bigger and certain industries have become over-represented in market indexes. Some that have benefited from growing index fund popularity are the sin sectors — tobacco and armaments being two notable culprits.

As fund managers have embraced index funds, they have unwittingly invested more of their clients’ savings in industries and businesses that, elsewhere in their business, they have actively sought to avoid.

Passive funds are not only passive in selecting stocks, but also in their treatment of companies they invest in. They don’t visit management, lobby companies or vote to change practices to encourage “good corporate citizenship”.

Perhaps it is unrealistic to expect these two investing trends to be complementary. You can’t be passionate and passive at the same time.

It will be interesting to see which of the two proves more important to investors over time.