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.
3. Usage in Portfolios
All of these so-called passive products are also being used very actively. Let’s start with ETFs, which traded approximately $20 trillion worth of shares last year even though they only have $2.5 trillion in assets. That’s 800 percent asset turnover, which is about three times more than stocks. Arguably, ETF usage is active investing on steroids.
But what about investors who use ETFs and index funds long-term and don’t trade? They, too, are using them actively via asset allocation. The choice of how much of each asset class to have in a portfolio is actually the most active decision an investor can make, as the vast majority of a portfolio’s returns can be attributed to the asset allocation decisions (while stock and bond selection accounts for a small minority).
4. Engagement With Companies
Right now, index funds and ETFs via Vanguard and BlackRock own 12 percent of the stock market. (This number is expected to grow quickly, with 75 cents of every new dollar invested in the U.S. going into these two companies’ index-based products.) The role these “passive” issuers play in being shareholders of the companies they own is, again, more active than most think.
Both firms have made it a mission to affect corporate governance at companies they own via passive funds. They have internal teams that do nothing but “engage” with companies on issues to help create long-term value, such as keeping independent boards; installing ESG policies; employing better communication practices; and fighting for one vote, one share. While they tend to avoid strategic issues, they have at times voted with activists. They are also part of the Investor Stewardship Group (ISG), which is a collective of institutions representing $17 trillion in assets that seeks to establish a set of basic standards for corporate governance that will go into effect in 2018.
5. Above-Average Returns
Finally, some have a notion that passive investing means average returns. But index funds typically beat two-thirds of discretionary stock-picking managers out there who are burdened by higher fees and transaction costs. In this sense, shedding costs to ensure being above average is a very active decision.
This brings us to what the so-called “passive” trend is really about it: lower costs. Index funds and ETFs aren’t a way to be passive, but rather a way to get diversified exposure to different markets with as few hands on investors’ money as possible.
1The formal definition of passive from financial literature is a market-cap weighted basket of all stocks in the market. Anything outside of that is active. So you could say there are hardly any — and arguably no — truly “passive” funds.