Passive management

Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.[1][2] Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.[3]

The most popular method is to mimic the performance of an externally specified index by buying an index fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and low management fees. With low fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.[4]

One of the largest equity mutual funds, the Vanguard 500, is passively managed.[3] The two firms with the largest amounts of money under management, BlackRock and State Street, primarily engage in passive management strategies.

Rationale

The concept of passive management is counterintuitive to many investors.[3][5] The rationale behind indexing stems from the following concepts of financial economics:[3]

  1. In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore, the average investor will benefit more from reducing investment costs than from trying to beat the average.[1][6]
  2. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management,[7] although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
  3. The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance.[8][9]
  4. The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under some very strong assumptions, a fund indexed to "the market" is the only fund investors need to obtain the highest risk-adjusted return possible.[3] The CAPM has been rejected by empirical tests.

The bull market of the 1990s helped spur the growth in indexing observed over that decade. Investors were able to achieve desired absolute returns simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500, Russell 3000, and Wilshire 5000.[3][10]

In the United States, indexed funds have outperformed the majority of active managers, especially as the fees they charge are very much lower than active managers. They are also able to have significantly greater after-tax returns. This holds true when comparing both, mutual fund and the passive benchmark with the money market account, but changes by taking differential returns into account.[3][11]

Some active managers may beat the index in particular years, or even consistently over a series of years.[12] Nevertheless, the retail investor still has the problem of discerning how much of the outperformance was due to skill rather than luck, and which managers will do well in the future.[13]

Investment funds run by investment managers who closely mirror the index in their managed portfolios and offer little "added value" as managers whilst charging fees for active management are called 'closet trackers'; that is they do not in truth actively manage the fund but furtively mirror the index.

Implementation

The first step to implementing an index-based passive investment strategy is choosing a rules-based, transparent, and investable index consistent with the investment strategy's desired market exposure. Investment strategies are defined by their objectives and constraints, which are stated in their Investment Policy Statements. For equity passive investment strategies, the desired market exposures could vary by equity market segment (broad market vs. industry sectors, domestic vs. international), by style (value, growth, blend/core), or by other factors (high or low momentum, low volatility, quality).[14]

Index rules could include the frequency at which index constituents are re-balanced, and criteria for including such constituents. These rules should be objective, consistent and predictable. Index transparency means that index constituents and rules are clearly disclosed, which ensures that investors can replicate the index. Index investability means that the index performance can be reasonably replicated by investing in the market. In the simplest case, investability means that all constituents of an index can be purchased on a public exchange.[15]

Once an index has been chosen, an index fund can be implemented through various methods, financial instruments, and combinations thereof.

Implementation vehicles

Passive management can be achieved through holding the following instruments or a combination of the following instruments.

Index funds are mutual funds that try to replicate the returns of an index by purchasing securities in the same proportion as in the stock market index.[13] Some funds replicate index returns through sampling (e.g., buying stocks of each kind and sector in the index but not necessarily some of each individual stock), and there are sophisticated versions of sampling (e.g., those that seek to buy those particular shares that have the best chance of good performance). Investment funds that employ passive investment strategies to track the performance of a stock market index are known as index funds.[16][17]

Exchange-traded funds are open-ended, pooled, registered funds that are traded on public exchanges. A fund manager manages the underlying portfolio of the ETF much like an index fund, and tracks a particular index or particular indices. "Authorized participant" acts as market makers for the ETF and delivers securities with the same allocation of the underlying fund to the fund manager in exchange for ETF units and vice versa. ETFs usually offer investors easy trading, low management fees, tax efficiency, and the ability to leverage using borrowed margin.[18]

Index futures contracts are futures contacts on the price of particular indices. Stock market index futures offer investors easy trading, ability to leverage through notional exposure, and no management fees. However, futures contracts expire, so they must be rolled over periodically for a cost. As well, only relatively popular stock market indices have futures contracts, so portfolio managers might not get exactly the exposure they want using available futures contracts. The use of futures contracts is also highly regulated, given the amount leverage they allow investors. Portfolio managers sometimes uses stock market index futures contracts as short-term investment vehicles to quickly adjust index exposure, while replacing those exposures with cash exposures over longer periods.[19]

Options on Index Futures Contracts are options on futures contracts of particular indices. Options offer investors asymmetric payoffs that could limit their risk of loss (or gain, depending on the option) to just the premiums they paid for the option. They also offer investors the ability to leverage their exposure to stock market indices since option premiums are lower than the amount of index exposure afforded by the options.[20]

Stock Market Index Swaps are swap contracts typically negotiated between two parties to swap for a stock market index return in exchange for another source of return, typically a fixed income or money market return. Swap contracts exposure investors to counterparty credit risk, low liquidity risk, interest rate risk, and tax policy risk. However, swap contracts can be negotiated for whatever index the parties agree to use as underlying index, and for however long the parties agree to set the contract, so investors could potentially negotiate swaps more compatible with their investment needs than funds, ETFs, and futures contracts.[21]

Implementation methods

Full replication in index investing means that manager holds all securities represented by the index in weights that closely match the index weights. Full replication is easy to comprehend and explain to investors, and mechanically tracks the index performance. However, full replication requires that all the index components have sufficient investment capacity and liquidity, and that the assets under investment management is large enough to make investments in all components of the index.[22]

Stratified sampling in index investing means that managers hold sub-sets of securities sampled from distinct sub-groups, or strata, of stocks in the index. The various strata imposed on the index should be mutually exclusive, exhaustive (sum to make up the whole index), and reflective of the characteristics and performance of the entire index. Common stratification techniques include industrial sector membership (such as sector membership defined by Global Industry Classification Standard (GICS)), equity style characteristics, and country affiliation. Sampling within each strata could be based on minimum market-cap criteria, or other criteria that mimics the weighting scheme of the index.[23]

Optimization sampling in index investing means that managers hold a sub-set of securities generated from an optimization process that minimizes the index tracking error of a portfolio subject to constraints. These sub-sets of securities do not have to adher to common stock sub-groups. Common constraints include the number of securities, market-cap limits, stock liquidity, and stock lot size.[24]

Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients based on the principle that underperforming markets will be balanced by other markets that outperform. A Loring Ward report in Advisor Perspectives showed how international diversification worked over the 10-year period from 2000–2010, with the Morgan Stanley Capital Index for emerging markets generating ten-year returns of 154 percent balancing the blue-chip S&P 500 index, which lost 9.1 percent over the same period – a historically rare event.[13] The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.[13]

State Street Global Advisors has long engaged companies on issues of corporate governance. Passive managers can vote against a board of directors using a large number of shares. Being forced to own stock on certain companies by the funds' charters, State Street pressures about principles of diversity, including gender diversity.[25]

The Bank of America estimated in 2017 that 37 percent of the value of U.S. funds (not including privately held assets) were in passive investments such as index funds and index ETFs. The same year, BlackRock estimated that 17.5 percent of the global stock market was managed passively; in contrast, 25.6 percent was managed by active funds or institutional accounts, and 57 percent was privately held and presumably does not track an index.[26] Similarly, Vanguard stated in 2018 that index funds own "15% of the value of all global equities".[27]

Pension fund investment in passive strategies

Research conducted by the World Pensions Council (WPC) suggests that 15% to 20% of overall assets held by large pension funds and national social security funds are invested in various forms of passive funds- as opposed to the more traditional actively managed mandates which still constitute the largest share of institutional investments.[28] The proportion invested in passive funds varies widely across jurisdictions and fund type.[28][29]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly [30] for various reasons ranging from disappointment with underperforming actively managed mandates [28] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.[31] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.[29][31]

Criticism

Analysts at Sanford C. Bernstein & Co., LLC have criticized passive management as "worse than Marxism".[32] In their view, active market management and Marxism try to allocate resources optimally, while passive management increases correlation of stocks and impedes efficiency. Therefore, they advise policymakers to not undermine active management.

Analysts at Emperor Investments,Inc. argue that by the law of unintended consequences the rise of passive investing makes the market more and more inefficient, which in turn makes active investing more profitable.[33]

A number of other prominent investors have criticized passive management on a variety of grounds. Carl Icahn, Howard Marks and Michael Burry argue that passive indexing has led to distortion of stock prices or a bubble, particularly in the price of large company stocks; while Nobel Memorial Prize winner Robert Shiller described passive indexing as "a chaotic system".[34][35] Jeffrey Gundlach asserts that passive management has become a "mania" and an example of "herding behavior".[36] Jack Bogle, who popularized passive investing in the 1970s with Vanguard, raised concerns in 2018 about the three largest US passive investing firms (Vanguard, BlackRock and State Street) holding a disproportionate share of voting control over US corporations.[37]

It has been argued that large institutional investors owning shares across several companies in the same sector lead to reduced competition and higher prices to consumers.[38][39]

See also

References
  1. Sharpe, William. "The Arithmetic of Active Management". web.stanford.edu. Retrieved August 15, 2015.
  2. Asness, Clifford S.; Frazzini, Andrea; Israel, Ronen; Moskowitz, Tobias J. (June 1, 2015). "Fact, Fiction, and Value Investing". Rochester, NY. SSRN 2595747. Cite journal requires |journal= (help)
  3. Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
  4. William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor. May 1, 2002. Retrieved May 20, 2010.
  5. Passive investing is now the mainstream method, says Morningstar researcher MarketWatch
  6. John Y. Campbell, Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Invited address to the American Economic Association and American Finance Association. Atlanta, Georgia, January 4, 2002. Retrieved May 20, 2010
  7. "Efficient Market Hypothesis - EMH". Investopedia. Retrieved May 20, 2010.
  8. "Mutual Fund Managers' 2014 Is Another Flop". Businessweek.
  9. Agency Theory, Agency Theory Forum. Retrieved May 20, 2010.
  10. Mark T. Hebner, IFA Publishing. Index Funds: The 12-Step Program for Active Investors, 2007, ISBN 0-9768023-0-9.
  11. Frahm, G.; Huber, F. The Outperformance Probability of Mutual Funds. J. Risk Financial Manag. 2019, 12, 108.doi:10.3390/jrfm12030108
  12. Passive money management strategy actively crushing stock pickers | Breakout - Yahoo Finance Yahoo Finance
  13. John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
  14. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 4
  15. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 2
  16. "What is Passive Investing?". Passive Investing Zone. Retrieved May 1, 2017.
  17. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 15
  18. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 16
  19. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19-20
  20. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19
  21. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19-20
  22. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 25
  23. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 27
  24. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 27-28
  25. The Backstory Behind That 'Fearless Girl' Statue on Wall Street, Bethany McLean, Mar 13, 2017, The Atlantic.
  26. "Less than 18 percent of global stocks owned by index investors: BlackRock". Reuters. October 3, 2017. Retrieved December 18, 2018.
  27. Sheetz, Michael (December 17, 2018). "Gundlach says passive investing has reached 'mania' status". www.cnbc.com. Retrieved December 18, 2018.
  28. Rachael Revesz (November 27, 2013). "Why Pension Funds Won't Allocate 90 Percent To Passives". Journal of Indexes - ETF.com. Retrieved June 7, 2014.
  29. Chris Flood (May 11, 2014). "Alarm Bells Ring for Active Fund Managers". FT fm. Retrieved June 7, 2014.
  30. Mike Foster (June 6, 2014). "Institutional Investors Look to ETFs". Financial News. Archived from the original on July 15, 2014. Retrieved June 7, 2014.
  31. Rachael Revesz (May 7, 2014). "UK Govt. Leading Way For Pensions Using Passives". Journal of Indexes - ETF.com. Retrieved June 7, 2014.
  32. Bernstein: Passive Investing Is Worse for Society Than Marxism, Luke Kawa, August 23, 2016, Blooomberg Markets
  33. Passive Investing Could Soon Be Inefficient, Emperor Investments Inc. Retrieved February 17, 2019
  34. Howard Marks (2018), Investing Without People
  35. Carmen Reinicke (Aug 29, 2019). 'Big Short' investor Michael Burry is calling passive investment a 'bubble.' He's not the only finance luminary sounding the alarm. Business Insider, accessed 31 August 2019
  36. Michael Sheetz (17 December 2018). Jeffrey Gundlach says passive investing has reached a ‘mania’ – investors should avoid index funds CNBC.com, accused 31 August 2019
  37. Erin Arvedlund (08 December 2018) Vanguard founder John Bogle warns index funds becoming too big, accessed 31 August 2019
  38. Partnoy, Frank (August 8, 2017). "Are Index Funds Evil?". The Atlantic. Retrieved June 12, 2020.
  39. Azar, José; Schmalz, Martin C.; Tecu, Isabel (2014). "Competitive Effects of Common Ownership: Evidence from the Airline Industry". SSRN Electronic Journal. Social Science Research Network. doi:10.2139/ssrn.2427345. Retrieved June 12, 2020.

Further reading
  • Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
  • John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
  • M. Nicolas J. Firzli, "Passive Play: Disenchanted Asset Owners Going Low-Cost as the ‘Age of Austerity’ Lingers", Revue Analyse Financière 54 (2015): 68-70.
  • Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9
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