Postponed Rebalancings Highlight Active Nature of Passive Investing

May 4, 2020

Active is active, and passive is passive, and never the twain shall meet?

Although the financial press seems to draw a sharp line dividing the two approaches to investment management, the underlying reality is much more nuanced. Passive management has many elements of active decision making, whether during the index design process or discretionary decisions made around rebalances.

The recent decisions by index providers to postpone index rebalancings only highlight the commonality between passive and active management. For example, on March 13, S&P Dow Jones Indices announced that it would postpone the first quarter rebalancing of their equity indexes, deferring membership additions and deletions, along with other routine adjustments to index composition. In their press release, they stated that they made the decision to best “support our clients and govern our indices during this period of extreme global market volatility, market wide circuit breaker events and exchange closures.” Other index providers have made similar announcements over the past weeks.

In other words, index providers made an active investment decision, based on a consideration of market conditions and client objectives, to change their approach – the type of decision that is more associated with traditional active managers.

But while the market volatility spurred by the COVID-19 crisis has put a spotlight on the active decision making that underlies passive index construction, the observation that indexes have much in common with active management is hardly new.

For instance, in a paper titled “The (Mis)Uses of the S&P 500,” Adriana Robertson of the University of Toronto Faculty of Law argues that the S&P 500 incorporates “a substantial amount of discretionary decision making.” She suggests that the index is far from a “buy and hold” portfolio given the number of changes in its composition and that decisions regarding membership involve considerable discretion.

Robertson concludes that the S&P 500 is “not ‘neutral’ or ‘universal’ in any meaningful sense.” Furthermore, investors who base their portfolios on the index are effectively “delegating management” of their portfolios to the S&P Index Committee.

In other words, Robertson confirms the Council’s view that it’s impossible to draw a sharp dividing line between active and passive management. Instead, it makes more sense to think of a full spectrum of investment options incorporating varying combinations of passive and active elements.

Current market conditions only make it clear that investment offerings can and do move along that spectrum, as investment managers of all types adapt to circumstances to better serve their clients. When evaluating any investment – whether categorized as active or passive – investors should understand how that investment might change as a result of the manager’s decisions and how those changes could affect the overall portfolio.