How to Move Away from Index Funds and Invest in the Next Economy
Last time we discussed how traditional index funds and ETFs can be viewed as a trap, keeping us all invested in the most destructive parts of the incumbent and legacy economies. Parts like fossil fuels, which in any case make for poor long-term investments because they can’t safely coexist with our global economy much (if any) longer.
So, because many of the technologies represented in the S&P 500 are dangerous and/or inefficient, holding those may put you on more uncertain ground going forward. The Federal Reserve Bank of San Francisco recently published an Economic Letter on the Fed’s role in climate change, writing, “Even long-term risks can have near-term consequences as investors reprice assets for a low-carbon future…climate-based risk could threaten the stability of the financial system as a whole and be of macroprudential concern.” Or as former SEC commissioner Bevis Longstreth has written, “It is entirely plausible, even predictable, that continuing to hold equities in fossil fuel companies will be ruled negligence.”
What these people are saying is that we need to think about what risk really is, and not what the big index says it is. But if not indexing, what? What’s a better approach, if our goal is mitigating the portfolio risks the Fed and commissioner Longstreth warn about?
First, know what you own. Here’s a way to think about the long-term viability of an enterprise: Ask yourself, is the company solving a real problem and adding real value, or is it mainly rent-seeking? Then ask, is the company paid to increase productivity and defuse system-level risks, or is it paid to make the economy less stable, or more toxic, or in some way to magnify our risks? Hold those questions in mind, then look at every stock you own. Are your investments likely to be stable going forward? To be “future proof?”
If that sounds like a lot of work, it is. And I think that goes a long way to explaining why most people prefer to fall back on the simplicity of indexing.
What about the other problem with indexing, that by monopolizing our assets it ties our hands, preventing us from getting more portfolio exposure to the best new innovations and solutions? Knowing what you own and avoiding portfolio level climate and resource risk is a start—it means you’re not allocated in the wrong ways—but getting toward exposure to where the economy is going next requires more. As I wrote here in Worth last year, “Investing only in the components of this next economy requires us to think less like stock portfolio managers and more like venture capitalists, even with our regular stock investments. In light of a rapidly shifting economic risk and reward landscape, investors need to seek out what concepts are going to meaningfully address resource, climate and social risks. Then, they need to identify which firms are producing solutions that can grow at scale, address a largely unmet market and are disrupting their legacy counterparts with business models that reward their owners.” If that sounds like a lot of work, it is. And I think that goes a long way to explaining why most people prefer to fall back on the simplicity of indexing and live with the cognitive dissonance of knowing their portfolios, and even the sustainability of the global economy, are at risk.
But I believe we need to evolve, and that’s why we founded Green Alpha Advisors in the first place: to develop portfolios that simultaneously avoid climate and resource degradation risks, and to give our clients exposure to the most dynamic innovations available in the equity markets today, all within well diversified, institutional quality strategies. As a result, we’re the beneficiaries of pent up demand from investors who understand that you can’t keep correlating closely with the economy that was and have legitimate diversification with appropriate portfolio exposure to what’s solving our big problems.
We don’t have to fall into the trap. We don’t have to accept the inherited idea that diversification means fossil fuels and glyphosate. We can define our own view of risk in light of the new reality, and we can act and invest accordingly. That most economic growth today resides where innovation and solutions meet is the benefit we realize from our redefinitions of conventional wisdom. It’s time to stop acting as if the S&P 500 is our only choice.