Are passive funds investing too much in fossil fuel companies?

The think-tank Commonwealth delved into an issue regarding the financial sector, with particular attention on the UK, but that can be considered a worldwide phenomenon, starting from the US. In the paper “The Passive Revolution” by Buller and Hayes, it is shown that passive investments are significantly increasing and that their exposure to fossil fuel companies may be a problem.

The share of equity owned by passive and active investors has been converging lately in the United Kingdom. From the beginning of the century, the passive funds’ share of FTSE All-share market capitalization increased from roughly 1% to 12%. The share held by active funds is still twice the one held by passive funds, but the gap has significantly shrunk. In 2001, active funds held ten times what passive funds did. 

After the 2008 financial crisis, however, the passive fund sector gained popularity because investors liked the possibility to track the market and invest with lower fees. An interesting thing to notice is that, while the market share held by active funds increased mainly because there are more funds out there, passive funds’ share increased also because their size increased. Therefore, compared to some years ago there are more passive funds and of bigger size, on average. Actually, around 2015, the average of total net assets for the passive funds industry exceeded the active ones for the first time, and it is still the case nowadays. While passive funds still represent a smaller fraction of shareholders compared to their active counterparts, their power is in the hands of a few powerful actors, that can shape the market and heavily influence capital allocation among firms, such as US giants Vanguard and BlackRock. 

This matter does not seem to be a climate-related problem but, in reality, the link is much simpler than one could think. In recent times, active funds started investing less in fossil fuel companies, as the general awareness for global warming and ESG investment increased. On the other hand, passive funds could not switch investments as easily as active funds can. This significantly altered the number of shares of fossil fuel companies owned by passive funds with respect to active ones. This trend influenced other industries as well, but the fossil fuel sector (oil, gas, coal, and related operations) was affected more than any other.

Passive funds hold firms from all industries, in line with their index weighting, and by nature do not adjust their portfolios. They try to faithfully replicate the market or follow indexes, and therefore cannot avoid buying certain types of assets, including non-ESG-friendly stocks. This overrepresentation of passive funds in the fossil fuels sector is making them become holders of last resort of this type of firm.

The question that the paper presents is which economy we want to live in, especially considering the process of decarbonization. It is not easy to deal with this matter from a regulatory standpoint. How could one blame an ETF for simply investing according to indexes? Indeed, investors could put pressure on stewardship teams that manage passive funds, but their margin of action is still lower compared to active fund managers. Renouncing the possibility of investing passively in the market seems unlikely, but some firms (including some of the giants mentioned above) are issuing green ETFs, and therefore investing in this type of fund could be a fair middle ground between passive and green investments.

Are passive funds investing too much in fossil fuel companies?

The think-tank Commonwealth delved into an issue regarding the financial sector, with particular attention on the UK, but that can be considered a worldwide phenomenon, starting from the US. In the paper “The Passive Revolution” by Buller and Hayes, it is shown that passive investments are significantly increasing and that their exposure to fossil fuel companies may be a problem.

The share of equity owned by passive and active investors has been converging lately in the United Kingdom. From the beginning of the century, the passive funds’ share of FTSE All-share market capitalization increased from roughly 1% to 12%. The share held by active funds is still twice the one held by passive funds, but the gap has significantly shrunk. In 2001, active funds held ten times what passive funds did. 

After the 2008 financial crisis, however, the passive fund sector gained popularity because investors liked the possibility to track the market and invest with lower fees. An interesting thing to notice is that, while the market share held by active funds increased mainly because there are more funds out there, passive funds’ share increased also because their size increased. Therefore, compared to some years ago there are more passive funds and of bigger size, on average. Actually, around 2015, the average of total net assets for the passive funds industry exceeded the active ones for the first time, and it is still the case nowadays. While passive funds still represent a smaller fraction of shareholders compared to their active counterparts, their power is in the hands of a few powerful actors, that can shape the market and heavily influence capital allocation among firms, such as US giants Vanguard and BlackRock. 

This matter does not seem to be a climate-related problem but, in reality, the link is much simpler than one could think. In recent times, active funds started investing less in fossil fuel companies, as the general awareness for global warming and ESG investment increased. On the other hand, passive funds could not switch investments as easily as active funds can. This significantly altered the number of shares of fossil fuel companies owned by passive funds with respect to active ones. This trend influenced other industries as well, but the fossil fuel sector (oil, gas, coal, and related operations) was affected more than any other.

Passive funds hold firms from all industries, in line with their index weighting, and by nature do not adjust their portfolios. They try to faithfully replicate the market or follow indexes, and therefore cannot avoid buying certain types of assets, including non-ESG-friendly stocks. This overrepresentation of passive funds in the fossil fuels sector is making them become holders of last resort of this type of firm.

The question that the paper presents is which economy we want to live in, especially considering the process of decarbonization. It is not easy to deal with this matter from a regulatory standpoint. How could one blame an ETF for simply investing according to indexes? Indeed, investors could put pressure on stewardship teams that manage passive funds, but their margin of action is still lower compared to active fund managers. Renouncing the possibility of investing passively in the market seems unlikely, but some firms (including some of the giants mentioned above) are issuing green ETFs, and therefore investing in this type of fund could be a fair middle ground between passive and green investments.

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