Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 126

Passive investment – an unwitting oxymoron

I’ve always loved the term 'oxymoron', and I equally love using it whenever I can. Some of my favourite examples include: unbiased opinion, deafening silence and bittersweet (to name a few). One oxymoron I have been hearing more recently and which bothers me, however, is ‘passive investment’.

Given that the term 'investment' refers to the allocation of one asset for another, often with the sole purpose to generate a return, to describe an investment as passive is somewhat of an oxymoron. To use cash to buy equities is an active investment decision. To move money out of active into passive strategies is not only an 'active' allocation, but each day it is left untouched is yet another active allocation. One can only attach a modifier of 'low-fee investment' to this active decision.

Market cap index does not represent broad equity market

Aside from my own philosophical bent towards active investing, there is another more compelling reason why I flag this classic oxymoron. It can cloud traditional benchmarking, a central pillar of the investment management industry. It is important to benchmark and monitor the decisions taken by others. In the world of active asset management, more often than not, this is through comparisons with market cap indices. But in reality, market cap indices are not a perfect representation of the broader equity market.

All portfolios, even benchmarks, are a product of their portfolio construction equation. Market cap is a simplistic portfolio construction formula, which is derived from the summation of each company’s shares outstanding multiplied by its share price. This portfolio construction method dictates that price momentum can play a significant role in how this index portfolio performs.

Let’s take a simplistic example using the S&P/ASX 100. If one single stock outperforms the rest of the 99 stocks within this portfolio of 100 holdings by a ratio of two to one, its allocation/weight within the benchmark will rise, while the remaining 99 names will show a modest reduction in portfolio weight. Conversely, were this stock to underperform by half that of the remaining 99 names, its allocation within the 100 name index portfolio would fall. Price momentum, or to be specific, its relative price performance, clearly influences its final allocation and weighting. If the portfolio construction decision is based on price and shares outstanding, it is not too surprising that price momentum plays a significant role in the performance patterns of an index portfolio.

Inappropriate benchmark for a value investor

This can be problematic for index benchmarking as few active equity managers use price momentum as an active philosophy when valuing their investment. While it is true that many use price momentum as a timing indicator, active managers use other metrics in identifying their strategic investment decisions. When assessing active equity managers, is a price momentum portfolio the right benchmark?

I suspect that this is partly why a number of academics have been endorsing 'smart beta'. Academic Barr Rosenburg long ago stipulated that there were three main factors determining systematic-market returns: size, value and price momentum. Smart beta can now look through a framework of size, value, price momentum and any number of other factors that drive systematic returns.

That much is known, but what is not as widely discussed is the role that momentum plays in market cap indices. A market cap index portfolio could just as easily be deemed a smart beta option towards the price momentum factor. If so, to assess an active manager’s portfolio through a price momentum benchmark could yield misleading conclusions, given that active portfolio managers use other metrics.

This is concerning as decisions about the value-add from active managers are being made on the basis of market cap benchmarks, which at some points in the cycle are heavily skewed towards a single factor (price momentum). In periods when price momentum is driving market returns, intuitively active managers will find it difficult to outperform an index. However, the reverse is also true, when momentum is not a factor driving market returns that is when the active manager should be adding real value.

Move to index introduces price momentum influences

In response to continued market uncertainty, coming at a time when many Baby Boomers are moving towards their drawdown phase, many investors are looking to de-risk their portfolios by seeking 'passive' alternatives. But there is no such thing as a passive investment. And while accessing a market cap weighted portfolio does neutralise the risk of relative underperformance from a benchmark, investors do so by embracing price momentum. In highly uncertain markets, price momentum-influenced portfolios add to overall market volatility given market caps ‘buy and hold’ portfolio construction.

Every investment is an active one. Investors must understand the consequences of moving towards market cap weighted, or price momentum beta portfolios. While it is true that fee budgets are lowered, everything comes at a cost in our quest to maximise risk-adjusted net returns. And an investor’s goal should not be minimising cost, but maximising returns.

 

Rob Prugue is Senior Managing Director and Chief Executive Officer at Lazard Asset Management (Asia Pacific). This article is for general education purposes and readers should seek their own professional advice before making any financial decisions.

7 Comments
Rob Prugue
September 18, 2015

The purpose of a good debate is to open ourselves up to discussions out of our comfort zone. In this regard, I hope this short missive does this inasmuch as hopefully challenging a belief that passive investing is an option (all investments are active, by definition), and that while managing to a fee budget is important, it is not the key driver in determining NET and uncorrelated returns.

Regardless, while I do accept the aforementioned points, my own take is respectfully slightly different inasmuch as my preferring to differentiate the word "investing" from "trading". As any investor, we own the assets and its intrinsic worth is a function of earning/cashflow/divis/book value, not a function of price. Valuations then move up/down based on what other investors are willing to pay for such an implied return. So to say that if the world were 100% passive, would that necessarily change the fact that we own its intrinsic returns, and that companies income statements can and will vary?

I know, you're talking to a die hard. But then again, never was one who believed we live in a physicist's "vacuum".

Happy hunting my fellow investors.

SMSF Trustee
September 18, 2015

Hi Gavin, this is a good discussion to be having.

I can't agree with your belief that the market would deliver a nil return if there were only passive investors.

First, the companies would make earnings and pay dividends. So there would be that simple income return at best.

Second, assuming that there is a flow of passive investments coming and leaving the stock market, there would be transacting. As earnings grow - or fall if a company struggles - then the price at which those passive flows would transact would have to be based on some sort of valuation process. Let's be positive and expect that for the overall market there will be growth, then there will also be increasing share prices to reflect the fact that the NPV of the future income stream will keep on rising.

Third, just as with direct property holdings in a portfolio, investors could always also choose to have their holdings of shares in a totally passive market revalued. Again, as long as earnings grow, the share price will get revalued upwards.

Of course, if in theory we only had this sort of passive investing, the market would operate differently - eg more like the property market as per my point 3. It might make the stock market more attractive to a lot more investors if it took the speculative run ups and downs in prices out of the equation! The current operation of stock markets is what it is because there are active managers needing that level of liquidity to trade, but if there were a different set of investors, then stocks could be bought and sold in other ways than at the moment.

That's not going to happen of course and nor do I advocate for a change. My point is simply that many different assets operate in different types of markets. It's not the mode of that market's operation that results in returns, but the earnings the assets generate.

Gavin Rogers
September 16, 2015

As a financial adviser of over 20 years experience, I recommend a mix of passive and active strategies and investments to the majority of my clients, and I also hold a mix in my SMSF, so I'm not seeking to serve my own interests in my comments.

If you think logically about what I said, my comments were aimed at the fact that if everybody invested into "the" market by passive means, then the market would produce a nil return because no individual investor could bid up or down a particular stock included in that market.

As long as there are active investors in the market then passive investors will benefit (assuming the market goes up!), and it is in the interests of proponents of passive investing that there is a healthy dose of active investor participation.

SMSF Trustee
September 14, 2015

"Passive investing only generates a return thanks to the activities of active investors."

So? Active investors can only trade in the stocks they want to buy or sell if other investors, whether active or passive, are also trading. You could push this line further and say that growth investors need value investors to sell to them the companies they want to buy.

The point is, we are ALL dependent upon the existence of a market in order to participate in the market.

That is in no way an argument for or against any particular investment approach - active, passive or otherwise.

And Jerome's argument confuses me, too. Usually proponents of active management argue that they can exploit market inefficiencies, but now we're being told that passive managers need active managers to create an efficient market.

Will the spin of people in this industry seeking to serve their own interests never end?!

(I use a mix of active and passive in my portfolio, by the way. But I'm not trying to sell my management services to anyone else and that is not advice to anyone that they should do the same thing. My only advice is to be very careful about the arguments that proponents of anything put forward - they have to stack up analytically and factually, not just sound good.)

Gavin Rogers
September 11, 2015

To follow on from Jerome's comment, another fact is that a strategy of passive investing only generates a return thanks to the activities of active investors. If for example 100% of investors looking to invest into the S&P/ASX 100 (using Rob's example from his article) wanted to do so via an index fund or other passive approach, then no single stock would or could outperform or underperform any of the other 99 stocks.

This is an argument I've made previously and it's an issue that is ignored by proponents of passive investing.

Jerome Lander
September 11, 2015

Here is another oxymoron. Supposedly passive investing not only relies upon an active decision, but on active management providing price discovery and market efficiency. Given market action of late and frantic price movements one has to wonder whether active management is providing the market efficiency needed or whether central bankers and market players have turned certain markets in to something resembling a Chinese equity market casino!

David
September 11, 2015

The way that the word 'momentum' is used makes the suggestion that all short term movement is due to momentum. Of course it could be due to changing fundamentals as well.

 

Leave a Comment:

     

RELATED ARTICLES

The difficulties picking fund manager winners

Why active management needs a full cycle

The paradox of passive investing

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.