Passive investing, also known as passive management, has been gaining ground on active management for years. If it maintains its popularity, it is on track to become the dominant asset management style of 2019.
Academics and policymakers debate passive management, and there are conflicting opinions in the impact investing community, too. Some impact investors have embraced passive strategies, while others believe there are serious downsides.
What Is Passive Investing?
In this investing philosophy, managers build portfolios that represent a market as a whole, often tracking an index such as the Standard & Poor’s 500. Unlike active managers, passive managers don’t attempt to identify which investments will perform better than others. Instead, the goal is to hold a diverse range of assets and match the performance of the overall market.
Passive investing products include mutual funds and exchange-traded funds (ETFs), which would be ideally held for the long term. Costs of passive management are generally lower than with active management because the investing process can be largely automated and does not involve leveraging a manager’s expertise.
Passive investing started in the 1970s when academics argued that under certain theoretical assumptions, an investing strategy that reflects a market will outperform one that tries to exploit gaps in information or take advantage of knowledge of market conditions. Research has suggested that passive strategies tend to outperform active ones, although active management provides more personalized service for investors who have complex goals.
Passive Investing and Impact Investing
Passive investors pursuing impact often turn to ETFs. Since the first environmental, social, and governance (ESG) ETF was created in 2005, ESG ETFs have grown to cover $11 billion in assets under management. In 2018, a survey identified 69 ETFs that considered ESG factors, up from only 25 two years prior. Although that survey found that passive management accounted for only 8% of total ESG assets, momentum is growing. In 2018 and the first half of 2019, the influx of money to passively managed ESG funds was higher than to their actively managed counterparts.
The growth of socially responsible ETFs makes impact investing more accessible to retail investors, who frequently hold ETFs in 401(k)s but do not have access to more specialized products, such as those only available to accredited investors. Large passive investors have begun to influence companies in support of their values through proxy voting and shareholder engagement.
However, from an impact perspective, passive investing could have drawbacks. While passive investing is suitable for publicly traded investments, it is less relevant for vehicles like private debt. Passive investing is also incompatible with the extensive research and personalized screening some investors employ in support of their impact strategies. And passive managers may have less clout in dialogue with companies not only because there isn’t a credible threat that they will sell their shares, but also because they face cost pressures and other incentives that may discourage in-depth engagement. Still, some research suggests that passive ownership allows activist investors to be more effective.