Passive management

Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio.[1][2] Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.[3]

The most popular method is to mimic the performance of an externally specified index by buying an index fund. By tracking an index, an investment portfolio typically gets good diversification, low turnover (good for keeping down internal transaction costs), and low management fees. With low fees, an investor in such a fund would have higher returns than a similar fund with similar investments but higher management fees and/or turnover/transaction costs.[4]

The bulk of money in Passive index funds are invested with the three passive asset managers: Black Rock, Vanguard and State Street. A major shift from assets to passive investments has taken place since 2008.[5] The two firms with the largest amounts of money under management, BlackRock and State Street, primarily engage in passive management strategies.

History

The first US market indexes date to the 1800s. The Dow Jones Transportation Average was established in 1884 with eleven stocks, mostly railroads. The Dow Jones Industrial Average was created in 1869 with 12 stocks in industrial manufacturing, energy and related industries.[6] Both are still in use with modifications, but the Industrial Average, commonly called "The Dow" or "Dow Jones", is more prominent and came to be regarded as an important measure for the American economy as a whole. Other influential US indexes include the Standard & Poor's 500 (1957), a curated list of 500 stocks selected by committee, and the Russell 1000 (1984) which tracks the largest 1,000 stocks by market capitalization. The FTSE 100 (1984) represents the largest publicly traded in the UK, while the MSCI World index (1969) tracks stock markets of the entire developed world.

Unit investment trusts (UITs) are a type of U.S. investment vehicle that prohibits or severely restricts changes to the assets held in the trust. One such UIT is the Voya Corporate Leaders Trust (LEXCX), which as of 2019 was the oldest passively managed investment fund still in existence in the United States according to John Rekenthaler of Morningstar, Inc..[7] Founded in 1935 as the Lexington Corporate Leaders Trust, LEXCX initially held 30 stocks, closely modeled on the Dow Industrials, and prohibited the purchase of new asests apart from those related directly to the original 30 (as with mergers, spin-offs or acquisitions). Unlike later index funds that are usually cap weighted, with greater proportional holdings in larger companies, LEXCX is share weighted: "holding the same number of shares in each company regardless of price."[8] An evaluation by US News & World Report found the fund was passively managed: "for all intents and purposes, this fund's portfolio is on autopilot."[9]

The modern concept of passive management developed in the late 1960s and early 1970s.[10] Academic researchers in finance and investing, particularly Eugene Fama and colleagues at the University of Chicago, were able to make several critical discoveries. First, determining average annual growth rates for the American stock market over long periods. Second, proposing that most active management was unable to consistently outperform market averages. Third, demonstrating how management fees and trading commissions could be a significant drain on profits.

From this research, the idea of offering low-fee index funds gained popularity. Economist and Nobel Laureate Paul Samuelson testified before Congress in 1967 on the growing popularity of mutual fund companies. He cited research indicating a randomly selected portfolio of 20 stocks was likely to perform as well as, if not better than, the typical actively managed mutual fund.[10] Furthermore, Samuelson noted it was usually more profitable to invest in a mutual fund company rather than in their funds, and argued most funds demanded high fees for investing advice of dubious value. Samuelson urged the financial industry to offer index funds to the general public and in a later article wrote how brokerages "should set up an in-house portfolio that tracks the S&P 500 Index – if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess."[11]

In 1969, A. Michael Lipper III, later of Lipper Analytical Services, petitioned the Securities and Exchange Commission to create a fund tracking the 30 stocks Dow Industrial Average. His request was ignored.[10] Batterymarch Financial Management, a small Boston firm, began promoting an index fund in 1971 but didn't have paying customers until 1974.[10] Larger and more successful index funds were pioneered by John "Mac" McQuown and Rex Sinquefield .[10] [12] Starting in 1971, McQuown managed part of Samsonite's multi-million pension fund for Wells Fargo's San Francisco office as the head of Wells Fargo Investment Advisors. McQuown initially attempted an equal-weight index of all stocks traded on the New York Stock Exchange, but this proved too difficult to manage and he eventually turned to a cap-weighted S&P 500 index. McQuown's fund was ultimately sold to Barclays and then to BlackRock. Sinquefield, a University of Chicago graduate, opened a cap-weighted S&P 500 fund in 1973 while employed at the American National Bank of Chicago. After seven years, Sinquefield's fund had $7 billion under management. McQuown and Sinquefield both went on to work at Dimensional Fund Advisors (DFA).

Vanguard created an S&P 500 index in 1976, with Jack Bogle being inspired by Samuelson's writings on the subject.

In the 1970s, DFA and Vanguard were two of the earliest American investing companies to focus on passive management of investments, though with different strategies.

Rationale

The concept of passive management is counterintuitive to many investors.[3][13] The rationale behind indexing stems from the following concepts of financial economics:[3]

  1. In the long term, the average investor will have an average before-costs performance equal to the market average. Therefore, the average investor will benefit more from reducing investment costs than from trying to beat the average.[1][14]
  2. The efficient-market hypothesis postulates that equilibrium market prices fully reflect all available information, or to the extent there is some information not reflected, there is nothing that can be done to exploit that fact. It is widely interpreted as suggesting that it is impossible to systematically "beat the market" through active management,[15] although this is not a correct interpretation of the hypothesis in its weak form. Stronger forms of the hypothesis are controversial, and there is some debatable evidence against it in its weak form too. For further information see behavioural finance.
  3. The principal–agent problem: an investor (the principal) who allocates money to a portfolio manager (the agent) must properly give incentives to the manager to run the portfolio in accordance with the investor's risk/return appetite, and must monitor the manager's performance.[16][17]
  4. The capital asset pricing model (CAPM) and related portfolio separation theorems, which imply that, in equilibrium, all investors will hold a mixture of the market portfolio and a riskless asset. That is, under some very strong assumptions, a fund indexed to "the market" is the only fund investors need to obtain the highest risk-adjusted return possible.[3] The CAPM has been rejected by empirical tests.
  5. The passive investment strategy (buy-and-hold) is supported when there are both high levels of inflation and GDP growth.[18]

The bull market of the 1990s helped spur the growth in indexing observed over that decade. Investors were able to achieve desired absolute returns simply by investing in portfolios benchmarked to broad-based market indices such as the S&P 500, Russell 3000, and Wilshire 5000.[3][19]

In the United States, indexed funds have outperformed the majority of active managers, especially as the fees they charge are very much lower than active managers. They are also able to have significantly greater after-tax returns. This holds true when comparing both, mutual fund and the passive benchmark with the money market account, but changes by taking differential returns into account.[3][20]

Some active managers may beat the index in particular years, or even consistently over a series of years.[21] Nevertheless, Jack Bogle noted the retail investor still has the problem of discerning how much of the out-performance was due to skill rather than luck, and which managers will do well in the future.[22]

Investment funds run by investment managers who closely mirror the index in their managed portfolios and offer little "added value" as managers whilst charging fees for active management are called "closet trackers" or "closet indexers" that is they do not in truth actively manage the fund but furtively mirror the index. The concept of active share, a measure how much a fund deviates from its benchmark, has been identified as important in funds that consistently out-perform averages.[23]

Implementation

The first step to implementing an index-based passive investment strategy is choosing a rules-based, transparent, and investable index consistent with the investment strategy's desired market exposure. Investment strategies are defined by their objectives and constraints, which are stated in their Investment Policy Statements. For equity passive investment strategies, the desired market exposures could vary by equity market segment (broad market vs. industry sectors, domestic vs. international), by style (value, growth, blend/core), or by other factors (high or low momentum, low volatility, quality).[24]

Index rules could include the frequency at which index constituents are re-balanced, and criteria for including such constituents. These rules should be objective, consistent and predictable. Index transparency means that index constituents and rules are clearly disclosed, which ensures that investors can replicate the index. Index investability means that the index performance can be reasonably replicated by investing in the market. In the simplest case, investability means that all constituents of an index can be purchased on a public exchange.[25]

Once an index has been chosen, an index fund can be implemented through various methods, financial instruments, and combinations thereof.

Implementation vehicles

Passive management can be achieved through holding the following instruments or a combination of the following instruments.

Index funds are mutual funds that try to replicate the returns of an index by purchasing securities in the same proportion as in the stock market index.[22] Some funds replicate index returns through sampling (e.g., buying stocks of each kind and sector in the index but not necessarily some of each individual stock), and there are sophisticated versions of sampling (e.g., those that seek to buy those particular shares that have the best chance of good performance). Investment funds that employ passive investment strategies to track the performance of a stock market index are known as index funds.[26][27]

Exchange-traded funds are open-ended, pooled, registered funds that are traded on public exchanges. A fund manager manages the underlying portfolio of the ETF much like an index fund, and tracks a particular index or particular indices. "Authorized participant" acts as market makers for the ETF and delivers securities with the same allocation of the underlying fund to the fund manager in exchange for ETF units and vice versa. ETFs usually offer investors easy trading, low management fees, tax efficiency, and the ability to leverage using borrowed margin.[28]

Index futures contracts are futures contacts on the price of particular indices. Stock market index futures offer investors easy trading, ability to leverage through notional exposure, and no management fees. However, futures contracts expire, so they must be rolled over periodically for a cost. As well, only relatively popular stock market indices have futures contracts, so portfolio managers might not get exactly the exposure they want using available futures contracts. The use of futures contracts is also highly regulated, given the amount leverage they allow investors. Portfolio managers sometimes uses stock market index futures contracts as short-term investment vehicles to quickly adjust index exposure, while replacing those exposures with cash exposures over longer periods.[29]

Options on Index Futures Contracts are options on futures contracts of particular indices. Options offer investors asymmetric payoffs that could limit their risk of loss (or gain, depending on the option) to just the premiums they paid for the option. They also offer investors the ability to leverage their exposure to stock market indices since option premiums are lower than the amount of index exposure afforded by the options.[30]

Stock Market Index Swaps are swap contracts typically negotiated between two parties to swap for a stock market index return in exchange for another source of return, typically a fixed income or money market return. Swap contracts exposure investors to counterparty credit risk, low liquidity risk, interest rate risk, and tax policy risk. However, swap contracts can be negotiated for whatever index the parties agree to use as underlying index, and for however long the parties agree to set the contract, so investors could potentially negotiate swaps more compatible with their investment needs than funds, ETFs, and futures contracts.[31]

Implementation methods

Full replication in index investing means that manager holds all securities represented by the index in weights that closely match the index weights. Full replication is easy to comprehend and explain to investors, and mechanically tracks the index performance. However, full replication requires that all the index components have sufficient investment capacity and liquidity, and that the assets under investment management is large enough to make investments in all components of the index.[32]

Stratified sampling in index investing means that managers hold sub-sets of securities sampled from distinct sub-groups, or strata, of stocks in the index. The various strata imposed on the index should be mutually exclusive, exhaustive (sum to make up the whole index), and reflective of the characteristics and performance of the entire index. Common stratification techniques include industrial sector membership (such as sector membership defined by Global Industry Classification Standard (GICS)), equity style characteristics, and country affiliation. Sampling within each strata could be based on minimum market-cap criteria, or other criteria that mimics the weighting scheme of the index.[33]

Optimization sampling in index investing means that managers hold a sub-set of securities generated from an optimization process that minimizes the index tracking error of a portfolio subject to constraints. These sub-sets of securities do not have to adher to common stock sub-groups. Common constraints include the number of securities, market-cap limits, stock liquidity, and stock lot size.[34]

Globally diversified portfolios of index funds are used by investment advisors who invest passively for their clients based on the principle that underperforming markets will be balanced by other markets that outperform. A Loring Ward report in Advisor Perspectives showed how international diversification worked over the 10-year period from 2000–2010, with the Morgan Stanley Capital Index for emerging markets generating ten-year returns of 154 percent balancing the blue-chip S&P 500 index, which lost 9.1 percent over the same period – a historically rare event.[22] The report noted that passive portfolios diversified in international asset classes generate more stable returns, particularly if rebalanced regularly.[22]

State Street Global Advisors has long engaged companies on issues of corporate governance. Passive managers can vote against a board of directors using a large number of shares. Being forced to own stock on certain companies by the funds' charters, State Street pressures about principles of diversity, including gender diversity.[35]

The Bank of America estimated in 2017 that 37 percent of the value of U.S. funds (not including privately held assets) were in passive investments such as index funds and index ETFs. The same year, BlackRock estimated that 17.5 percent of the global stock market was managed passively; in contrast, 25.6 percent was managed by active funds or institutional accounts, and 57 percent was privately held and presumably does not track an index.[36] Similarly, Vanguard stated in 2018 that index funds own "15% of the value of all global equities".[37]

Pension fund investment in passive strategies

Research conducted by the World Pensions Council (WPC) suggests that 15% to 20% of overall assets held by large pension funds and national social security funds are invested in various forms of passive funds- as opposed to the more traditional actively managed mandates which still constitute the largest share of institutional investments.[38] The proportion invested in passive funds varies widely across jurisdictions and fund type.[38][39]

The relative appeal of passive funds such as ETFs and other index-replicating investment vehicles has grown rapidly [40] for various reasons ranging from disappointment with underperforming actively managed mandates [38] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.[41] Public-sector pensions and national reserve funds have been among the early adopters of passive management strategies.[39][41]

Return-Chasing Behavior

At the Federal Reserve Bank of St. Louis, YiLi Chien, Senior Economist wrote about return-chasing behavior. The average equity mutual fund investor tends to buy MUTUAL FUNDS with high past returns and sell otherwise. Buying MUTUAL FUNDS with high returns is called a “return-chasing behavior.” Equity mutual fund flows have a positive correlation with past performance, with a return-flow correlation coefficient of 0.49. Stock market returns are almost unpredictable in the short term. Stock market returns tend to go back to the long-term average. The tendency to buy MUTUAL FUNDS with high returns and sell those with low returns can reduce profit.[42]

Unsophisticated short-term investors sell passive ETFs during extreme market times. Passive funds affect the price of stocks.[43]

Active management vs. passive

Active Managers do not practice "Buy and Hold." At least 80% of active managers fell below their respective benchmarks across all domestic equity categories over 15 years. All domestic funds had a 44% survivor rate of over 15 year, so a Survivorship Bias Correction is made. Survival is a measure that represents the proportion of funds that exist at the beginning of the period and remain active at the end of the time period.[44]

Criticism

Criticism has been leveled at passive investment by investors like Howard Marks[45] Carl Icahn, Michael Burry and Jeffrey Gundlach[46] who argue that asset bubbles can be considered a byproduct of the increasing popularity of passive investing. John C. Bogle of The Vanguard Group, while a staunch advocate for passive investing overall, also argued in 2018 that the growth in passive management firms would soon result in a concentration of over half of American stock ownership, and associated proxy voting power, among three large firms (Vanguard, State Street Global Advisors and BlackRock). Bogle stated: "I do not believe such a concentration would serve the national interest".[46]

In 2017, Robert Shiller, a Nobel Prize winning economist at Yale University, stated passive index funds are a "chaotic system" and "kind of pseudoscience" due to what he described as an over-reliance on computer models and a neglect of the businesses whose stocks make up index funds. [47]

According to researchers with the Federal Reserve who published their findings in 2020, the growing popularity of passive investing has increased some risks for investors and the economy generally, but reduced other risks. "Some passive strategies amplify market volatility, and the shift [towards passive investing] has increased industry concentration, but it has diminished some liquidity and redemption risks."[48]

In response, defenders of passive investing argue that some claims against the strategy are incorrect, and that other claims are partially accurate but overstated.[49]

See also

References
  1. Sharpe, William. "The Arithmetic of Active Management". web.stanford.edu. Retrieved August 15, 2015.
  2. Asness, Clifford S.; Frazzini, Andrea; Israel, Ronen; Moskowitz, Tobias J. (June 1, 2015). "Fact, Fiction, and Value Investing". Rochester, NY. SSRN 2595747. Cite journal requires |journal= (help)
  3. Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
  4. William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor. May 1, 2002. Retrieved May 20, 2010.
  5. Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk | Jan Fichtner, Eelke M. Heemskerk and Javier Garcia-Bernardo | Business and Politics 2017; 19(2): 298–326 | Conclusion
  6. Judge, Ben (May 26, 2015). "26 May 1896: Charles Dow launches the Dow Jones Industrial Average". MoneyWeek.
  7. John Rekenthaler (2019-12-24). The Strange and Happy Tale of Voya Corporate Leaders Trust: A fund that shouldn’t succeed, but does. Morningstar.com, accessed 02 November 2020
  8. James P. O'Shaughnessy (1997). What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time, NY: McGraw-Hill, 0-07-047985-2, p. 9
  9. [https://money.usnews.com/funds/mutual-funds/large-value/voya-corporate-leaders-trust-fund/lexcx Voya Corporate Leaders Trust Fund: Overview. US News &World Report. Accessed 2020-11-02
  10. Justin Fox (2009) The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street. HarperCollins
  11. Paul A. Samuelson. Challenge to Judgment. The Journal of Portfolio Management Fall 1974, 1 (1) 17-19; DOI: https://doi.org/10.3905/jpm.1974.408496
  12. Cooperman, Jeannette (June 23, 2009). "The Return of the King". www.stlmag.com. Retrieved March 14, 2019.
  13. Passive investing is now the mainstream method, says Morningstar researcher MarketWatch
  14. John Y. Campbell, Strategic Asset Allocation: Portfolio Choice for Long-Term Investors. Invited address to the American Economic Association and American Finance Association. Atlanta, Georgia, January 4, 2002. Retrieved May 20, 2010
  15. "Efficient Market Hypothesis - EMH". Investopedia. Retrieved May 20, 2010.
  16. "Mutual Fund Managers' 2014 Is Another Flop". Businessweek.
  17. Agency Theory, Agency Theory Forum. Retrieved May 20, 2010.
  18. Is Buy and Hold Investing Really Dead? | William F. Johnson University of Memphis - Finance | Abstract | Last revised: 6 Feb 2015
  19. Mark T. Hebner, IFA Publishing. Index Funds: The 12-Step Program for Active Investors, 2007, ISBN 0-9768023-0-9.
  20. Frahm, G.; Huber, F. The Outperformance Probability of Mutual Funds. J. Risk Financial Manag. 2019, 12, 108.doi:10.3390/jrfm12030108
  21. Passive money management strategy actively crushing stock pickers | Breakout - Yahoo Finance Yahoo Finance
  22. John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
  23. Antti Petajisto (2013). Active Share and Mutual Fund Performance. Financial Analysts Journal, Volume 69, Number 4.
  24. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 4
  25. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 2
  26. "What is Passive Investing?". Passive Investing Zone. Retrieved May 1, 2017.
  27. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 15
  28. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 16
  29. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19-20
  30. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19
  31. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 19-20
  32. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 25
  33. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 27
  34. Smith, David M.; Yousif, Kevin K., Passive Equity Investing, CFA Institute, p. 27-28
  35. The Backstory Behind That 'Fearless Girl' Statue on Wall Street, Bethany McLean, Mar 13, 2017, The Atlantic.
  36. "Less than 18 percent of global stocks owned by index investors: BlackRock". Reuters. October 3, 2017. Retrieved December 18, 2018.
  37. Sheetz, Michael (December 17, 2018). "Gundlach says passive investing has reached 'mania' status". www.cnbc.com. Retrieved December 18, 2018.
  38. Rachael Revesz (November 27, 2013). "Why Pension Funds Won't Allocate 90 Percent To Passives". Journal of Indexes - ETF.com. Retrieved June 7, 2014.
  39. Chris Flood (May 11, 2014). "Alarm Bells Ring for Active Fund Managers". FT fm. Retrieved June 7, 2014.
  40. Mike Foster (June 6, 2014). "Institutional Investors Look to ETFs". Financial News. Archived from the original on July 15, 2014. Retrieved June 7, 2014.
  41. Rachael Revesz (May 7, 2014). "UK Govt. Leading Way For Pensions Using Passives". Journal of Indexes - ETF.com. Retrieved June 7, 2014.
  42. copied from the wikipedia article Market timing "Chasing Returns Has a High Cost for Investors | St. Louis Fed On the Economy". copied from wikipedia article Buy & Hold
  43. Todorov, Karamfil, Passive Funds Actively Affect Prices: Evidence from the Largest ETF Markets (November 14, 2019). Available at SSRN: https://ssrn.com/abstract=3504016 or http://dx.doi.org/10.2139/ssrn.3504016
  44. copied from wikipedia article Buy & Hold S&P Dow Jones Indices | year 2019 | see pages 4, 7 of 32 | Survivorship Bias Correction
  45. Howard Marks (2018), Investing Without People, Oaktree.com, retrieved 2020-12-28
  46. Carmen Reinicke (Aug 29, 2019). 'Big Short' investor Michael Burry is calling passive investment a 'bubble.' He's not the only finance luminary sounding the alarm. Business Insider, retrieved 2020-12-25
  47. Stephanie Landman (2017-10-14) Passive investing is a ‘chaotic system’ that could be dangerous, warns Robert Shiller. CNBC.com, retrieved 2020-12-28
  48. Anadu, Kenechukwu and Kruttli, Mathias S. and McCabe, Patrick E. and Osambela, Emilio, The Shift From Active to Passive Investing: Potential Risks to Financial Stability? (May 15, 2020). Available at SSRN: https://ssrn.com/abstract=3244467 or http://dx.doi.org/10.2139/ssrn.3244467
  49. James J. Rowley, Jr., CFA; Joshua M. Hirt; Haifeng Wang, Ph.D. "Setting the Record Straight: The Truth About Indexing" (Jan 2018). Vanguard.com

Further reading
  • Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
  • John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
  • M. Nicolas J. Firzli, "Passive Play: Disenchanted Asset Owners Going Low-Cost as the ‘Age of Austerity’ Lingers", Revue Analyse Financière 54 (2015): 68-70.
  • Mark T. Hebner, Index Funds: The 12-Step Program for Active Investors, IFA Publishing, 2007, ISBN 0-9768023-0-9
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