Money Matters

Can Index Funds Be a Force for Sustainable Capitalism?

(Source: hbr.org)

The investment industry is changing. There is growing demand from investors for better environmental and social outcomes, and more resources going into index fund or quasi-indexing products. These two trends may seem separate, but together they have the power to improve finance’s role in the world. Index funds can be a force for sustainable capitalism. But when it comes to firms pursuing environmental and social goals, how can we overcome free rider problems, to make sure companies are incentivized to have a more positive societal impact? One answer is “pre-competitive collaborations”, in which industries come together to develop industry standards, generate data, create industry knowledge, or fuel product development. And certain types of financial institutions are well-suited to assist with these efforts.

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Hiroshi Watanabe/Getty Images

The investment industry is changing. Among other things, there is growing demand from both retail and institutional investors to align their capital with better environmental and social outcomes, and more resources going into index fund or quasi-indexing products. These two trends may seem separate—or, some people believe, incompatible—but together I believe they have the power to improve finance’s role in the world. Index funds can be a force for sustainable capitalism.

Socially conscious investing is exploding as a practice and at some point I expect it to be indistinguishable as a product or service or category. All investment practices will consider environmental, social, and governance (ESG) metrics because some of those metrics are financially material, meaning decision-useful pieces of information. Just look at Uber to understand the importance of diversity and product safety or at car manufacturers scrambling to develop a competitive advantage in electric cars as countries seek to decarbonize their economics and fight pollution. In both cases, social and environmental metrics matter for the business’s financial success.

This is not just case-by-case evidence. Research by my co-authors and myself has found that firms improving their performance on industry-specific, material ESG issues outperform their competitors, and firms disclosing more information on industry-specific material ESG issues exhibit more informative stock prices and as a result more efficient pricing of risks and opportunities.

Index funds, meanwhile, are a cause of heated debate. Some see them as a natural evolution, and a smart choice for many non-professional investors. It is tough to beat the market and over long periods of time indexing has been shown to outperform most active managers. On the other side, fans of active management see it as a trend that can damage market efficiency and lead to distortions in market prices. If most of the market is in “passive” investment, prices won’t adjust properly and capital will be allocated less efficiently. The debate is far from settled and will likely go on for a long time. However, indexing represents an opportunity that is seldom talked about, to further the cause of sustainable investment.

The opportunity is to remove incentives for free-riding within industries where a firm might take advantage of another firm’s efforts in addressing a social or environmental issue. While, overall, the evidence suggests that firms with better ESG performance outperform their competitors, there are cases where this will not be true. First, there is the “customer does not want to pay problem”: in some cases, consumers are not willing to pay more for “green” products, and in most cases only subsets of the customer base for specific products are willing to choose greener products. As a result, firms that take costly actions to source products in a sustainable way could find themselves with a higher cost structure and lower profitability margins, and as a result at a competitive disadvantage. Second, there is a time horizon problem: while in some cases increasing wages or selecting suppliers with better labor practices might bring a financial benefit in the long-term, short-term pressures on the business might make business leaders averse to making such investments. The market for corporate control, the design of executive compensation packages, and the board of directors’ evaluation horizons could be barriers to such decisions.

How can we overcome these free rider problems, to make sure companies are incentivized to have a more positive societal impact? One answer, I believe, is what I call “pre-competitive collaborations,” in which industries come together to develop industry standards, generate data, create industry knowledge, or fuel product development. Before explaining how these collaborations can help, it’s important to note that we observe them already in several industries, spanning mining to technology. (These collaborations happen in a transparent way and should not be confused with the harmful collusion tactics that we should be vigilant about.)

For instance, denim industry leaders in Amsterdam have come together, with the help of the Amsterdam University of Applied Sciences, to form the Alliance for Responsible Denim (ARD). The goal of ARD is to produce denim in a sustainable way by tackling the three main ecological issues the industry faces: water, energy, and chemicals. In another example, GSMA, the trade body representing mobile operators, has developed a framework to collaborate in maximizing their contribution towards the SDGs, in particular improving infrastructure, reducing poverty, providing quality education, and acting on climate.

The International Council on Mining and Metals’ has developed transparency principles for mining firms while the Responsible Care program of the chemical industry focuses on outcomes ranging from employee safety to environmental impact. Similarly, the Global Agri-business Alliance is developing an agreement for companies operating in different parts of the agriculture value chain on standards of conduct for improving livelihoods of farmers, among other outcomes.

By banding together, firms in an industry can make life harder for free riders who seek to act less responsibly. By setting clear standards and releasing data, these collaborations help show the market which firms are committed to ESG and which ones are shirking.

But what’s the role of investors? In my research, I lay out a framework suggesting that investors are a potential mechanism to build and sustain such pre-competitive collaborations, addressing deforestation in the food industry, water pollutants in the apparel industry, material sourcing in the electronic equipment industry or obesity and health in the eating and drinking places industry.

Consistent with the framework in my research, several investors have started to engage at the industry level, endorsing or even assisting with these pre-competitive collaborations.” For example, the Swedish AP funds, in collaboration with other investors in 2016, engaged ten companies regarding the management of fish and shellfish throughout supply chains and several companies that purchase cobalt mines in the Congo. Just a few weeks ago, the world’s largest fund, the Norwegian pension fund, partnered with UNICEF, to set up a network with some of the top fashion companies to improve children’s rights in the supply chain. The initiative will also focus on areas such as children education, and health and nutrition, from access to school to working mothers’ ability to breastfeed.

I identify two characteristics for investors that are likely to engage with companies at the industry-level on issues of environmental and social importance: a long time horizon for investments and significant common ownership of companies within the same industry or supply chain. The longer the time horizon, the more appealing many aspects of ESG, as mentioned above. And the more companies within an industry the investor owns, the more concerned they are with the industry as a whole, and the less favorably they view the conduct of free riders.

Three types of investors satisfy both criteria. First, large index asset managers, such as Blackrock, State Street, and Vanguard. These investors hold significant shares of equity and if a company remains in a given index they will keep holding the stock. Second, active institutional investors that are large enough to effectively becoming quasi-indexers (broadly diversified low-turnover portfolios) as they seek to limit index tracking error, such as Fidelity, JP Morgan, BNY Mellon, and Northern Trust. Third, large pension funds such as GPIF, Norges Bank Investment Management, AP, and New York Common Retirement Fund. These investors also tend to hold significant portions of the equity shares of many companies while at the same time matching assets to long-term liabilities. Large index and quasi-index investors have now built teams that engage with companies in their portfolios while large asset owners have been among the leaders in engaging with companies on environmental and social issues.

This does not mean that other investors do not have a role to play. In fact, I suggest that two other types of investors will play a significant role: socially responsible investment funds and individual investors. Socially responsible investment funds and investor organizations, such as CERES, have been effective at bringing environmental and social issues to the public domain putting pressure both on companies and larger investors to act. Moreover, the more individual investors care about the environmental and social attributes of their investments the less likely it is that asset managers will free-ride on other asset managers’ efforts. Consistent with this proposition, as individual investor interest in the ESG characteristics of their investments has grown, we have witnessed an increase in the number of asset managers that engage with companies.

The investment management industry has been highly commoditized. Technology has put pressure on management fees, and this will only continue. Moreover, industry consolidation and scale have led to most funds quasi-indexing, if not explicitly indexing. According to my estimates for every dollar actively managed, either through high turnover diversified portfolios or through low turnover concentrated portfolios, there are three dollars in indexing or quasi-indexing. In such a market there will be tremendous rewards for market participants that can provide a differentiated service. Engaging with companies to promote positive environmental and social outcomes and being able to document the impact of those engagements may well prove to be one of those differentiators.

More Info: hbr.org

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