Rise of the machines! Attack of the clones!
This is a common outcry from the financial industry and investors alike in reaction to the rapid rise of “passive” index funds and exchange-traded funds, which now have about $5 trillion in assets in the United States. Investors have an understandable tendency to see passive investing as a bunch of robotic investors putting money into robotic funds run by robots.
But if you examine all the aspects of passive investing — from the index construction to the usage to the management of the funds — there isn’t a whole lot robotic about it.1 In fact, it involves a lot of human decision-making. Here are five ways “passive” is actually active.
1: Index Construction
Investors and the media view some popular indexes as gospel in terms of being representatives of the market. But really, all of them are rules-based systems designed by humans (with a variety of motivations) who made decisions in constructing them. How do stocks get added and removed? Are there caps to one stock’s weight? How often will it rebalance? Reconstitute?
For example, the S&P 500 Index is overseen by committee of market professionals who basically decide what stocks to include. They’re literally stock picking, albeit not in the alpha-seeking sense. Or consider the Dow Jones Industrial Average, which only tracks 30 stocks — with seemingly random weightings determined by whatever the price per share is of each.
Index construction takes a truly active turn when it comes to smart beta, where people design indexes with all kinds of filters and tilts — typically copied from what worked for active managers in the past — in an effort to beat other indexes like the S&P 500. There’s really no daylight between this and what most typically consider “active.”
2. Portfolio Management
When it comes to running an index fund or ETF, it’s easy to imagine there’s no manager, or it’s perhaps some mainframe computer. But quite the contrary: A human portfolio manager is in that role, playing what can be referred to as a game of basis points. On one hand, they play defense by combating front-running; keeping up with dividends, spinoffs, and warrants; and trying to avoid capital gains. At the same time, they play offense by trying to eat up some of the expense ratio and inch closer to perfect tracking of the index via securities lending revenue and manager acumen.
You can tell how well passive managers play this game by using an underrated metric called “tracking difference,” which basically measures how far off an index fund or ETF is from its index’s return. This metric is arguably the true cost of the fund, since it is net of fees. For example, Gerard O’Reilly manages the Vanguard Total Stock Market Index Fund, which charges .05 percent, yet the fund has only missed its index over the last few years by .01 percent. Basically, the manager is rebating investors .04 percent via the game of basis points. And in a $428 billion fund, that’s $17 million a year back to investors. There are dozens of similar examples of managers delivering tracking difference that’s tighter than the expense ratio.