The rise of environmental, social, and governance (ESG) investing over the last few years also saw the rise of another trend: passive investing. According to an academic study, however, the combination of both could be dropping buckets of volatility into the capital markets.
The classic efficient market hypothesis notes that the price of a security takes into account all information available to investors. However, what happens when you skew the participants of the markets to favor one side — in this case, a deluge of more passive investing via indexes?
It’s a shift that’s been highlighted by major players in the capital markets looking to offer the cheapest products to investors, such as low-fee exchange traded funds (ETFs). What results is a price war among big name ETF providers, leading to the introduction of more passive index funds as new products get rolled out or fees are slashed on existing products.
Among those products are ESG funds, which have been rising in popularity over the last few years. Whether it’s buying individual stocks or ESG-focused ETFs, investors have been quick to follow the trend.
Regarding ESG, “the preference [to buy stocks in the index] is becoming stronger,” said Felix Goltz, research director at Scientific Beta. “People think [companies] are doing something harmful to society if they are not in the index so they care more about whether a stock is included.”
Therefore, “demand should be more inelastic for stocks included in ESG benchmarks. That should lead to higher prices for these stocks,” Goltz added. With more passive investing strategies in the capital markets, that means fewer opposing forces such as active management funds — as such, when markets move one direction, it’s amplified, thus causing more volatility.
An Active ESG Option
Investors looking to get ESG exposure but who also want the flexibility of active management in times of volatility can consider the American Century Sustainable Equity ETF (ESGA). In a time when “greenwashing” is becoming more rampant in the capital markets, active management can help purify holdings to stay in line with investors’ ESG preferences.
ESGA employs a multi-factor approach — growth, momentum, and value — for more factor diversification that can perform in any market. Additionally, the fund aims to construct a competitive portfolio with favorable risk/reward profiles and impressive ESG credentials.
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