The S&P 500 is Actively Managed: New Academic Thinking on Active and Passive

June 27, 2019

“Active is active, and passive is passive, and never the twain shall meet,” is the old thinking about investment alternatives. But investment practitioners today realize that the dividing line between active and passive is blurrier than once thought and that most investments lie somewhere on a spectrum between 100% passive and 100% active.

Two recent papers from the academic world emphasize that the active-passive landscape has changed dramatically in recent years –and may never have been as simple as most people believed.

Active Index ETFs

“The Active World of Passive Investing” takes a close look at ETFs and concludes that “many ETFs are active investments in both form and substance.” In fact, most ETFs are not just active; they’re “highly active” with a median active share of 93.1% and median tracking error of 8.8% per year.

To draw these conclusions researchers David Easley of Cornell University and David Michayluk, Maureen O’Hara, and Talis J. Putnins of the University of Technology Sydney compare the holdings of 413 U.S. equity ETFs to a passive market portfolio from 2000 to 2017. They noted several trends in their analysis:

• The most passive ETFs tend to be the largest in terms of assets under management, while, with some exceptions, the most active ETFs are smaller. However, active ETFs are still a significant portion of the ETF market. For example, “very active” ETFs account for 84% of the number of funds if only 43% of assets.
• The more active ETFs are often more actively traded, with annual turnover that, in some instances, is more than seven times their market capitalization. Active ETFs appear to be used to make short-horizon bets on sectors or factors.
• Newer ETFs are generally more active than older ETFs. The first ETFs were “largely passive,” but the ETF market has evolved to become more active.

In sum, the authors suggest that “ETFs are best viewed as a continuum of products across the passive-active space.”

The Active S&P 500

“The (Mis)Uses of the S&P 500” by University of Toronto professor Adriana Z. Robertson suggests that the confusion of passive with active is a long-standing phenomenon. This is Robertson’s second paper on the active-passive frontier. She previously authored “Passive in Name Only: Delegated Management and ‘Index’ Investing,” which highlighted the number of funds based on custom indexes.

In this new paper, Robertson takes a deep dive into the construction of the S&P 500, one of the most commonly-used benchmark indexes. Both investment performance and corporate performance are often evaluated against the yardstick of S&P 500 returns.

However, as Robertson notes, “little attention has been paid to the index itself.” She describes the role of the S&P U.S. Index Committee, which exercises considerable discretion, as evidenced by the frequent changes made to eligibility requirements. More importantly, her analysis suggests that the changes in eligibility requirements are “primarily responsible” for the performance of the index.

Robertson believes that this work has important implications for the use of the S&P 500, as a passive benchmark for evaluating performance, whether investment or corporate.

The Bottom Line

Drawing a sharp line between active and passive doesn’t make sense in today’s investment environment – if it ever made sense. Recent academic studies make it clear that even portfolios that are fully invested in index funds are likely to have an active component.