Passive investing, popularized in the 1960s, has gained momentum to become the primary investment strategy of private and institutional investors globally. Many investment managers have shunned active stock picking, as beating the market is extremely difficult to sustain and a costly means of managing capital. Passive investing has yielded better results due to reduced risks and fees, diversification benefits, and attractive returns over the long term.

However, this strategy has some downsides. Passive investors construct their portfolios to track a benchmark index (e.g., the S&P 500 or the NIFTY 500) without considering risks and opportunities such as climate change. The dominance of passive investing can, therefore, steer financial markets toward autopilot.

Key problem areas

Passive investors lack clear opportunities for influencing investee companies to take climate action. Active investors have the option to consider green aspects in their stock selection – and thereby encourage investees to adopt low-carbon technologies. However, the benchmark indexes that passive investors track do not usually differentiate between carbon-emitting and carbon-mitigating securities, and many include high-emitting companies. Given that passive fund managers have to hold these stocks in order to track the indexes, high-emitting companies may continue to receive high valuations. Passive investment, therefore, fails to mitigate the climate crisis and exposes portfolios to financial risks stemming from climate change.

Passive portfolios fail to divert investment away from assets that the green transition may render stranded in the future. Due to the short-termism of their approach, passive investors overlook the material risk of climate change in their investment decisions. As policies, regulations, and rapid technological progress in low-carbon technologies shift economies away from carbon-intensive means of production, fossil fuel-related and high-emitting companies may become stranded assets. Sudden changes in policy (e.g., a significant increase in carbon price) or a fall in the cost of low-carbon technologies (e.g., rendering electric vehicles more affordable) could drag down the market value of those companies that have been slow to adopt such technologies.

Passive fund managers may pass the blame on to indexes and their constituent companies for their lack of climate action. Passive fund managers usually cite the avoidance of tracking errors as their reason for retaining high-emitting companies in their portfolios. Citing index composition as the cause of their carbon investment, they look to investee companies to drive climate action. Such investors are indeed bound by their investment policy documents regarding portfolio allocation and are not at liberty to diverge from the indexes they track. However, fund managers also have a fiduciary duty to consider all kinds of material risks and opportunities associated with the benchmark index.

Where does the solution lie?

Refining passive investment management

Asset managers can leverage their investments to affect changes in an index’s composition without compromising their investment policies. Reducing tracking errors to zero is expensive, but investment policies allow some degree of error, enabling managers to tilt slightly toward companies with better decarbonization plans, thereby reducing the climate risk of their portfolios.

Fund managers may also seek to revise their investment policy documents to allow their portfolios to deviate slightly from the market index. If the investment decision-making process is sound, such deviation will not significantly change the portfolio’s performance compared to the market index in the short term.

An added benefit of this approach is reducing exposure to climate risk that the market is not considering, thereby resulting in better performance than the market index in the long term. Contributing to mitigating climate risk will reduce a fund’s volatility risk. Research shows that national climate policies can significantly affect stock index volatility. This means investors holding stocks that are resilient to climate change can better reduce stock performance volatility.

To effect such change, the focus should be on the investment decision-making process. Investment managers’ performance is monitored with increasing regularity, forcing them to prioritize short-term gains and increasing their chance of underperformance in the long term in the face of long-tail risks such as climate change.

Funds can become more sustainable and resilient by adopting investment management strategies that can succeed across various market cycles (e.g., periods of expansion and recession) and adapt to changing scenarios (e.g., increasing carbon pricing).

Passive investment managers who are committed to strong investment processes must recognize climate change as a key material risk and opportunity. By tilting their portfolios toward climate-resilient stocks without sacrificing the investment decision-making and management process, they could perform much better than their benchmark index, as several indexes are not fully considering climate change risks and opportunities.

Enhancing stewardship

Despite the heightened risks associated with fossil fuel investments, large asset managers have been disinclined to promote climate action among their investee companies, especially given that their stock prices have increased due to recent spikes in energy prices. Stewardship is an important aspect of investors’ fiduciary duty and a powerful instrument to encourage companies to integrate material climate change risks and opportunities into strategic planning and capital budgeting. Given their board-level representation in corporations, investors can influence the management to prioritize climate change considerations on corporate agendas.

Leveraging collaboration

Collaboration among large and powerful passive investment managers can shift the constituents of the market index by increasing the weightage of securities with robust low-carbon strategies and reducing or removing those without such plans.

Divesting high-emitting companies from their portfolios would decrease the value of these securities, thereby reducing their weightage in the benchmark indexes, and potentially leading to their removal. Large asset managers following passive investment strategy, with trillions of financial assets under management, can influence corporations to integrate climate change in business planning and strategy, and capital allocation. By slightly deviating the asset and securities allocation from the market index, these large investors can send signals to companies to invest in low-carbon technologies. Through collaboration, they can change the constituents of companies and exert pressure to integrate climate change more aggressively.

This article is also published on the Center for Sustainable Finance. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.