Responsible investment and the market cap weighted index: a contradiction in terms

In recent years there has been strong growth in passive investments. Although passive investments are often identified as investments that follow a market cap weighted index, that is not the only way to construct a passive portfolio. PRI recently published a discussion paper about incorporation of ESG in passive investments. It rightfully argues that passive investments are investments that do not require individual stock picking, but are based on certain rules. It is possible to develop a rule based passive portfolio on active insights including ESG-rules. At the same time approximately one third of PRI signatories report that they do not incorporate ESG in equity and fixed income investments because they are pursuing a passive investment approach. Essentially, they say that they cannot incorporate ESG because they have chosen to follow a market weighted index. This raises the question whether the choice for a market cap weighted index is compatible with their commitment to responsible investment. I would argue that it is not.

The market cap-weighted index (in its pure form) is not compatible with responsible investment and the incorporation of ESG factors in the investment process. Obviously, market cap-weighted indexes have certain advantages, such as spreading risks, low costs, their appeal to a feeling of neutrality to the development of the market (assuming markets are efficient) and their ability to deliver returns that closely track the wider market. These may all be valid considerations, but do not lead to a meaningful alignment between the investment approach and the organisation’s commitment to responsible investment. More importantly, it does not recognise some inherent shortcomings of the market cap weighted index. Above all, it does not acknowledge that ESG factors can and often are financially material. Let me elaborate on this ‘incompatibility’ a bit further.

A recent PRI discussion paper shows that incorporation of ESG factors in passive/rule-based investment strategies is possible. But I would argue, that incorporation of ESG in passive investments is not just a possibility, but a necessity. To further support that statement, let me try to demystify some issues around market cap-weighted indexes. It is important to distinguish between passive investments, which is an approach to investing, and a market cap-weighted index, which is a portfolio construction methodology. To shift from a strictly market cap-weighted index to a rule-based investment strategy that incorporates ESG, there are both push factors (away from the market cap-weighted index) and pull factors (attracting investors to other options). Relevant factors include: the (in-)efficiency of markets; failures of markets to price in material ESG factors; the occurrence of bubbles; the difference between companies paying dividends and companies hoarding cash; the issuance of additional shares or share buy backs and changes of the constitution of the index.If markets would be 100% efficient, all material ESG-issues would already have been incorporated. However, that is not the case. Depending on your preferred conclusion one will always find academic research that supports it. To prevent that, one would have to look at the full body of available research. That is exactly what the meta-study of the Hamburg University and Deutsche Asset Management (Friede, Busch and Bassen, December 2015, ESG & Corporate Financial Performance: Mapping the global landscape) has attempted to do. Their analysis of over 2,000 academic studies (and 60 meta studies), shows that only 10 percent of the studies display a negative relationship between ESG and corporate financial performance, while 48 percent display a positive relationship, and 23 percent and 18 percent display a neutral and mixed relationship respectively. It clearly shows that ESG factors have not (at least not yet) been priced in adequately. Consequently, we must conclude that markets are not always efficient, ESG factors are not always adequately priced in and there is a need to incorporate ESG-issues, also in rule-based passive investments.

The history of financial markets is littered with asset bubbles. It is not uncommon for asset prices to trade above what can be considered their fundamental fair value. For example, during the dot-com bubble of 1997 to 2000, the share prices of internet companies and related firms rose fast, in anticipation of expected growth. Rising share prices, easy access to capital and euphoria among investors created a market where share prices were not determined by expected revenues, solvency etc., but by the momentum of the market: as companies’ market capitalisation grew, it created additional demand as investors made active decisions to overweight tech stocks, further inflating share prices. Prior to the crash, the IT sector accounted for 32.3% of the S&P 500 market cap, compared with its 15-year average of 18.2%. The dot-com bubble is just one of the examples of how behavioural finance mechanisms undermine the efficiency of markets. Investors tracking market cap-weighted indexes were seriously affected.

A third issue to look at is the occurrence of corporate actions that affect the constitution of the index. Market cap-weighted indexes, like all passive investment strategies, require periodical rebalancing. If there have been no changes in the constitution of the index (with no companies leaving or entering the index, no major share issues or buyback programmes etc.), with only share prices changing, a market cap-weighted index is self-balancing, meaning that rebalancing costs are generally low. But corporate actions and other changes regularly lead to changes of the index and consequently rebalancing. The entry of a company into an index tends to lead to an immediate increase in its share price, as index funds are compelled to invest.
When companies’ fundamentals fall below certain thresholds, go bankrupt or have their shares de-listed for another reason, they are removed from the index. Corporate actions, such as paying dividends versus retaining profits, share buybacks, mergers and acquisitions or major spin offs, will also affect the index. Of the original 500 companies in the S&P 500, only around 80 companies remain in the index in its current form. Portfolio managers will need to buy and sell certain assets, usually at a time when many other investors do the same. This has a self-generating (negative) price effect of selling cheap and buying expensive.

Finally, the market cap weighted index may suffer from concentration risks. Companies can grow to the point that they take up an inordinate amount of space in an index. This is particularly relevant for smaller indexes, but theoretically applies across all indexes. As a company grows, index designers are obliged to appoint a greater percentage of the company to the index. This can endanger a diversified index by placing too much weight on one individual stock’s performance. This becomes a major burden if the concentration coincides with a bubble or otherwise overvaluing of certain stocks.For example, the largest 100 stocks in the S&P 500 represent approximately 65% of its value, and the largest 10 stocks (2% of its constituents) represent around 18-20%. An example of this type of risk is the case of BP and the Deepwater Horizon crisis in the Gulf of Mexico in 2010. At that time, BP represented more than 9% of the value of the FTSE 100. Over the period of the crisis, BP’s share price dropped more than 50%, wiping close to 5% off the value of the FTSE 100.

Market cap-weighted indexes are easy to explain and cheap. However, they also have clear disadvantages, not least that they fail to take material ESG factors into account. Investors should consider whether the disadvantages outweigh the advantages. However, as long as ESG factors are undervalued, there is a strong case for any investor to consider other options, including the incorporation of ESG factors in an alternative, rule-based passive investment strategy. If you think the shortcomings of market cap weighted index are material, and if you are genuine in your commitment to responsible investment, and wish to turn that ‘active insight’ into ‘passive delivery’ you will find the PRI publication a helpful paper to find your way in the world of ESG-rule based passive investments.

Kris Douma is Director of Strategic Projects at the PRI.