Closet Active: Why indices aren't as passive as they seem

A recent study of US equity indices and the 'passive' funds tracking them found that a significant amount of decision-making was being entrusted to index creators by fund managers. We examine the implications for climate indices and risks for the growing number of investors tracking them.

Published 05.07.2021 by Nick Henderson

At the G7 summit in June, leaders committed to a "green revolution" that would limit global warming to 1.5°C and reach net-zero carbon emissions by 2050. They also agreed to boost climate finance, which is both necessary and opportune as investors' desire to invest sustainably continues to break new records.

According to Morningstar, global assets in sustainable mutual and exchange-traded funds (ETFs) rose to nearly $2 trillion at the end of March 2021, up 17.8% on the previous quarter and nearly double the level a year earlier. Reassuringly for the G7 countries given the private investment required to reach their targets, ESG funds with an environmental or climate theme have been among the best-selling products of 2021.

Another megatrend alongside the growth of sustainable investment has been the rise of passive investing. Over the past decade, passive funds globally received inflows of $3.8 trillion, compared to outflows of $185 billion for actively managed funds (see chart). The market share of passive funds has steadily risen over this period from 21.7% to 41.0% of total assets. There are also a growing number of indices available for these funds to track. According to the 2020 Index Industry Association (IIA) annual survey, over three million indices exist globally, 60 times more than the number of companies listed around the world.

Closet Active



Unsurprising, ESG-themed indices are the fastest growing segment of the market. Globally they rose by 40.2% in the past year according to the IIA – the largest year-on-year increase in any single major index class in the survey’s four-year history – following growth of 13.9% from 2018 to 2019. While the rapid expansion is positive in steering capital flows towards more sustainable funds, with three providers – FTSE Russell, S&P Dow Jones and MSCI – representing over two thirds (68.3%) of market share, it also raises questions about their construction, potential conflicts and use by investors.

Passive in name only

According to the Cambridge Dictionary, passive is defined as "not acting to influence or change a situation; allowing other people to be in control". However, a recent studyof US equity indices and the 'passive' funds tracking them found that a significant amount of decision-making was being entrusted to index creators by fund managers: "Index investing is better understood as a form of delegated management, where the delegee is the index creator rather than the fund manager… The fact that an investor “passively” follows an index does not imply that the index itself is passive."

For investors, the quality and transparency of the decision-making being delegated to index providers is important, particularly as the study found there to be wide-ranging differences between similar strategies. We examine the implications for climate indices and risks for the growing number of investors tracking them.