Passive investing has never been popular. This presents us with unforeseen challenges and also opportunities, especially in the ESG and Impact investing area. We are here to discuss the opportunities.
The financial market allows capital to be flown to the areas where it is needed. Given the current conditions of environmental damage and social inequality, our society is requiring more capital to be allocated to these areas. Unfortunately, these areas don’t yield monetary profit, yet there can be positive results, i.e positive externality.
Though we have seen a lot of progress in ESG investing, many mainstream investors are still reluctant to choose companies based on metrics that meet high environmental and social governance standards. One of the biggest challenges is not having a publicly accepted standard on those criteria. This is where index fund can be helpful.
In general, an Index fund is a collection of stocks that met pre-determined rules. For an index to become the basis for investment strategy, it must be:
- Rules – based
- Transparent
- Investable
Rules – based. NASDAQ 100 Index includes the stocks of the largest 100 companies in market size that are traded on the NASDAQ exchange. When any of the companies that are traded on the NASDAQ exchange reaches the top 100 in market size, it gets to be included in the NASDAQ 100 Index. This gives the new stock an additional demand as those funds that track the index will buy the company’s stock without doing deep fundamental analysis. This is where the ESG and Impact investing principles would be applied.
Transparent. The passive investor and institution need to understand the rules underlying the index selection. This rule needs to be clear and transparent to the public
Investable. Any investor who is interested in tracking the index must be able to replicate in the market without massive challenges.
In addition to distributing more capital to those companies that meet the ESG Index standards, those firms that run the Index funds can have larger influence through their stakeholder involvement. The larger the ESG index fund gets, the more influence it can have through its shareholder engagements.
As companies try to be included in the ESG index, executives will try their best to be more innovative with their approach to production. Since being included in an index almost automatically adds more appreciation in their stock price, there could be a capital gain to the investors.
The blueprints of creating such an index can be complex but it is achievable.
