A large part of the world’s wealth is invested through passively traded, index-following funds, and with good reason, relating to risk aversion. I provide an argument that applying a similar method to donating to charity may bring about better outcomes, given we incorporate effectiveness metrics into the selection criteria for the index.

1. Why Follow Indexes?

Do so because it very likely provides the optimal risk/benefit ratio. In the investment world it’s been a long debate whether active or passive trading will be more profitable. The common wisdom is “investing passively into the S&P 500 should beat almost all active traders in the long run, and it’s almost impossible to pick the ones that won’t.” Many fit this hypothesis to historical data, and it seems to be true for a large proportion of past moments in time when an investment could have been made - given you would have had the guts to wait “for the long run” to come.

Stock markets are samples from the world economy. People play two games at the same time on them.

The first game is to participate in the gains of the economy growing (as Adam Smith described it in The Wealth of Nations). That growth is often around 1-3% a year after we subtract inflation. So for the sake of thinking, just imagine a long-term average steady growth - a straight, slightly sloping line on a chart. This game is not zero sum. Investing into a passively traded, index-following fund is dedicating ourselves to this game exclusively. It’s called “buying the market”.

The second game is a zero sum game. It’s about to take more from the growing pool than others. It’s called “beating the market”. In fact, it’s just playing a poker variant with a very complex ruleset. This is what we hope for with active trading.

2. Not All Indexes Created Equal

Statistically speaking, indexes are sampling structures. The Dow Jones Industrial Average takes 30 companies from the USA. It weights these based on the price of a single stock. It’s a historical index, and given how many companies are in the USA, it just doesn’t provide a good, representative sample. The most famous example, the S&P 500 takes into account the 500 leading US companies. It’s weighted by market capitalization, which is equal to market price per common share multiplied by the number of common shares on the market. It’s providing a much better statistical sample of the economy. The MSCI ACWI Equal Weighted is a global index (ACWI stands for All Country World Index). It samples about 2700-2800 companies from both developed and emerging markets. “Equal Weighted” means every company has the weight of one. Some may argue it’s somewhat close to being a representative sample, taken from the world economy. It still filters out war zones and countries with high instability.
So indexes have sample size, filtering criteria, and weighting methodology. Indexes are rebalanced periodically, because weighting changes, and companies cross filtering criteria barriers from time to time. The closer the index is to being a representative sample, the more closely it follows the trajectory of the total economic growth. Some companies will do (much) better than the market average, some (much) worse. We don’t know which ones upfront, so our best bet is going for the market average.

3. Applying This to Charity

When we buy a stock, we make a bet in the hope of profit. Whenever we donate to charity, we make a bet in the hope of doing good. Some charities have been more cost effective than others. Some execute better. Some will have higher impact, some lower. We can investigate their past, and draw conclusions based on that. We may pick some by hand (like in active trading), or we may create a weighting structure based on the available insights from these charities’ past (their current “stock price”). But just as with profitable companies, we don’t know these charities’ future. So let’s draw some conclusions from the analogy of active and passive trading on stock markets!

First, we hope for an optimum: the most good done (this is our “profit”) with the least risk possible. This is very similar to investment. If we accept this, it looks plausible that “index-following” is superior to “hand picking” in the long run. We should focus on creating good indexes to follow.

For example, imagine an index consisting of the top 30 most cost effective charities across the world. We could rebalance this index every 6 or 12 months. We could have equal weights, or weight it by expenditure, or expenditure times a measure of cost effectiveness (seems analogous to market cap), or some other measures of results (may be hard to have that right).

Second, at some point in the process of improving the weighting structure of an index, we’ll hit the wall of diminishing returns. That’s the point when we should aim for bigger samples. Because we still have risks. Some charities will perform very well, but some will underperform. We already have a best practice to offset this kind of risk: make a charity portfolio of 500 charities instead of 30.

We could have an “S&P 500”, or even “MSCI ACWI EW” for charities. The cost of managing the latter might be too high (too much investigation might be needed for each rebalance), but the former seems relatively easy to compose. By doing so we would benefit from about 140 years of portfolio theory advancement, applied to doing good.