01142019

Index Investing — Not As Passive As  You May Think

January 14, 2019

Study: Index investing not as passive as you might think

To passive investing aficionados, a new study from Adriana Robertson, assistant professor in the University of Toronto law faculty, may be a bit surprising. Professor Robertson’s "Passive in Name Only: Delegated Management and 'Index' Investing," analyzed more than 900 indexes, including 603 that are used as benchmarks for 3,208 mutual funds and concluded that index investing isn’t really that passive. 

Like so many investment decisions, the act of creating an index is, in itself an active decision. She writes, "Instead of being truly passive, tracking an index almost always implies choosing a managed portfolio. Not only are these indexes managed portfolios in the strictly financial sense, by their construction they imply a substantial amount of delegated decision-making authority."

As detailed by Rick Baert in a recent article for Pensions & Investments, Robertson argues that "rather than being passive in any meaningful sense, index investing simply represents a form of delegated management.” In her paper issued in November, Robertson illustrates how index investing is no different from active management. “We have this idea in the back of our minds that indexes are passive because they’re divorced from active management decision-making. But like active management, indexes are just the result of decisions by people.”

“Professor Robertson’s study offers a thoughtful reminder that ultimately all investing incorporates some active element – which reinforces the Active Managers Council’s view that the active/passive “debate” does investors a disservice by ignoring the value that active management adds to investment portfolios and planning, ” says Karen L. Barr President and CEO Investment Adviser Association (IAA).

Anne Lester, Global Head of Retirement Solutions, J.P. Morgan Asset Management advises that “Every choice investors make is an active choice, including the choice to go passive or active. Effective portfolio construction, we believe, will use a wide spectrum of investment strategies—from pure market cap weighted to the most concentrated high-conviction portfolios to more targeted factor exposures. In combination, they will complement one another in a well-diversified portfolio—but investors need to know what they own, why they own it and how it contributes to their targeted outcome.”

David Lafferty, senior vice president and chief market strategist at Natixis Investment Managers, Boston, and chairman of the research task force of the IAA’s Active Managers Council, was quoted in P&I indicating he agrees with the paper’s premise.

"Investors tend to see the differences between active and passive as very black and white," Mr. Lafferty said. "Their intuition is that when you buy a passive fund, you're buying the market. However, this misses a key point that passive strategies are derived from indexes, and the creation of those indexes is a very active process. Investors are not simply buying the market, they are effectively buying how the index provider defines that particular market."

Those decisions, Mr. Lafferty said, include "which securities to include, how they are removed, and how frequently the index is rebalanced. The active decision about which securities to include can be further broken down into decisions on size, liquidity, quality or myriad other factors. These active construction rules can have an enormous impact on the return profile of a passive strategy, especially those that are focused on more niche areas, like smart beta or factor-based indexes."

Whether it’s the act of creating an index or the choice to go active or passive with your portfolio, active decisions permeate all investing. To learn more about the value of active management, visit our YouTube Channel for full presentations from Anne Lester, David Lafferty and other industry experts or our Insights section which includes a growing library of research and commentary on the industry.