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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.

 

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