It’s hard to find somebody with an interest in investments who hasn’t been bombarded from all sides with information on the active vs passive debate. Entire rainforests have been destroyed by active fund managers publishing literature to try and combat the growing popularity of passive investing.
For those who haven’t been subject to such bombardment, ‘passive’ investing is generally thought to be investing in a fund (either an index fund or an ETF) that tracks an underlying index, like the FTSE 100 or S&P 500. The fund will produce an almost identical return to the index, with the hope being that the index will provide a better return than those funds trying to beat it. On the other side of the coin, ‘active’ investing is investing in funds who try to beat the index. Proponents believe that the index can be beaten, and try to select funds/stocks that will outperform over the long run.
Yet despite how frequently the terms ‘active’ and ‘passive’ are used, there’s still much confusion around what they actually mean. Let’s start with an example: an ETF that tracks the FTSE 100 – active or passive? Most would say passive. But what if the ETF is bought and sold 12 times a day as part of regional based day-trading strategy? That doesn’t sound very passive. Another example: how about an ETF that tracks the FTSE 100 Value index? Again, most would say passive. Yet picking stocks based on their value score is exactly what some quantitative hedge funds do. Few would argue that a rules-based quant hedge fund charging 2 and 20 is passive, but if you bundle the same strategy up into an ETF wrapper and charge 20 basis points, does it then become a passive strategy?
The main point of confusion seems to stem from the differentiation between an active strategy and an active vehicle.
An active strategy is one which tilts its asset allocation away from the global market portfolio (see the next post for a discussion on the global market portfolio), and periodically adjusts its asset allocation to try and outperform the market. For example, most investment managers will adjust their asset allocation based on the macro-economic environment and over/underweight particular countries/sectors. Any deviation away from the global market portfolio country/sector weights can be thought of as an active bet on a specific region or sector – you are betting that you know more about the prospects for that region or sector than the market does. An active strategy does not buy and hold, but continually adjusts its allocations to try and beat the market.
An active vehicle is a fund that’s designed to outperform a market-cap weighted benchmark. For example, a UK equity fund designed to outperform the FTSE 100 is an active fund. There can be any number of ways for an active vehicle to try to outperform the market (unique stock insights, factor-driven, trend-following, etc), and the stock selection doesn’t even have to be made by a human. Systematic strategies, automated to remove human biases, are thought of as active, as they’re programmed with the intention of outperforming the benchmark.
Where confusion seems to arise is the idea of ‘smart beta’ strategies, or really any strategy that tracks an underlying non-market index. Many smart beta strategies are labelled as ‘passive’ as they track an underlying factor-based benchmark, such as the MSCI USA Value Index, or the MSCI USA Small Cap Index. Although the vehicles (usually ETFs) are tracking a factor-based benchmark, the intention is for the funds to outperform the larger market-cap weighted benchmark. Quantitative factor-based strategies such as those championed by the likes of AQR and Winton Capital are clearly thought of as active, so how can those ETFs trying to profit from the same factors be thought of as passive?
People assume that all indices are completely judgement-free (hence the ‘passive’ moniker), but the reality is that an index can be created to track almost any set of stocks. I could create an index called the ‘Stocks beginning with the letter Q’ index, and then create an ETF to track it. I’d be making the active bet that stocks beginning with the letter Q are likely to outperform the market – and that’s the very definition of active management.
Even indices designed to capture traditional factors have judgement applied to them. For example, the Russell 2000 Index and the S&P Small Cap 600 Index both claim to track the small-cap spectrum of the US market. However, the performances of the 2 are surprisingly different – the Russell 2000 has an annualised return of 8.21% over the last 5 years, but the S&P Small Cap 600 has returned 10.21% – a 2% annualised difference:
The difference is down to index construction criteria. Whilst both indices track the same small-cap segment of the US market, the S&P index includes only those companies where the sum of the most recent four consecutive quarters’ earnings are positive, as are the most recent quarter’s. The Russell 2000 index includes no such criteria. Even two of the largest index providers in the world disagree on how best to measure the performance of US small caps.
The bottom line is that all index construction is subjective – based on what the index provider considers to be a sensible way to capture a particular factor or characteristic. How they decide to measure that characteristic, how many factor characteristics they decide to measure in a stock, and how the characteristics are weighted in significance are all considered, and all have room for judgement. For example, is a low P/B ratio a good ‘value’ characteristic? Many have argued it’s not. Should you therefore give less of a weighting to the P/B measure? Do you take the bottom quartile of P/B stocks, or stocks with a P/B below a certain value? How often do you remeasure book value?
All this complexity is all captured in one incredible statistic: according to a study conducted by the Index Industry Association: there are now 70 times as many indexes as there are quoted stocks in the world. The study estimates there are over 3 million indices in existence, versus just 43,000 quoted stocks. Whilst not all of these indices will be factor indices (some track market niches other than factors), it’s clear that there’s an almost infinite number of ways to construct a factor-based index, with each index slightly different to the others – all with the aim of best capturing a particular factor. Index construction is just as focussed on selecting stocks to outperform a market-cap benchmark as traditional active stock picking.
A passive strategy is buying and holding, with an asset allocation/regional exposure/sector exposure as close as practicably possible to the market’s weights. For example, a portfolio that buys a fund that tracks the MSCI World and holds it indefinitely would be a passive strategy. The holding is reflective of the equity market’s regional and sector weights, and the regional/sector allocation is never changed by the investor in an attempt to outperform. The passive investor does not try to beat the market by adjusting allocations, but believes the market is priced efficiently enough that trying to outperform is futile over the long run.
Passive vehicles are funds that attempt to replicate the performance of a market-cap weighted benchmark. For example, an ETF that attempts to replicate the performance of the MSCI World or FTSE 100 index would be a passive vehicle. The benchmarks they are trying to replicate are market-cap weighted, and again, there is no effort by the fund manager or index provider to try and outperform.
Active strategies, passive vehicles
Whilst ETFs are usually thought of as passive vehicles, the reality is that most ETFs are actively traded – they are passive vehicles being used in active strategies. The SPDR S&P 500 ETF ‘SPY’ is the most actively traded security on the planet. Over the year ending 30th April 2017, the average holding period for SPY was 15.4 days:
Despite it being a passive vehicle, an asset with a holding period of just over two weeks cannot be thought of as passive. Active allocators are using ETFs to gain broad exposure to specific markets in their active strategies, and are trading them based on their preferences for regional exposure.
There is further evidence from Vanguard who, based on data from Morningstar, show that US investors are using index funds to track indices other than the Vanguard Total Stock Market:
As Ben Carlson of Ritholtz Wealth Management says – “All index funds aren’t good just like all active funds aren’t bad and all index investors aren’t passive just like all non-index investors aren’t active.”
Can anyone be truly passive?
Investing in a 100% passive strategy using 100% passive vehicles would involve investing in every asset class in the world according to its relative size. The resultant portfolio would be the ‘global market portfolio’, which would reflect the entire wealth of the world, and would form the basis for the ultimate index fund. But how investable is this portfolio? And would you actually want to invest in it? The next post ‘Can anyone be truly passive? In search of the Global Market Portfolio‘ explores this question.