Can someone tell me what passive investment means? (and other dumb questions)

Ours is a wonderful industry for using terminology that confuses the professionals let alone the customers. You know what I mean, basis points instead of per centages, asset managers instead of fund managers and my favourite, government paper for Gilts. We regularly hear the phrase “Passive investment”. You might think you know what it means. Experience over hundreds of interviews tells me I do not. Does it matter? Yes, it probably does. We need to be clear what we are telling our customers.

So what do we mean when we use the term ‘passive’ as an investment methodology?  The typical answer is along the lines of, “We don’t believe active managers add value, so we invest in passive funds.”

Of course, that demands the follow up, “what passive funds?” and this is where it can get silly. Again, the typical answer is “we invest in the index.” You’ve guessed the follow up – “what index?” This is where the fun really starts.

There are is another question:

Is the argument for passive purely one of cost i.e. the benefits of active management will be offset, and more, by higher cost, or one of investment philosophy i.e. you will obtain a superior return over time investing across all markets rather than try to pick winners within specific markets, or is it, perhaps, a combination of both?

Despite all of the hundreds of interviews that I have conducted, I am no wiser as to the true answer. To find the answer, the two questions that I have asked are:

  • Do you believe in active asset allocation?
  • How do you decide what asset classes are incorporated in portfolios?

Many fans of the ‘A random walk down wall Street’ argue against active asset allocation. The purist practitioners of this philosophy stick to a 60/40% equity/bond mix style. Once again this begs questions of government versus corporate and of the nature of bond markets over time. Certainly, the government bond market has been distorted out of all recognition over recent years, partly due to regulation forcing banks, pensions schemes etc to hold them, when they would not for pure investment reasons, and then the colossal purchase of stock by governments in QE programmes. This has, at the extreme, resulted in bonds being priced to guarantee a negative return. Whatever happened to the time value of money? Other issues in corporate bond markets are liquidity and concentration risk. Surely these must make the index buyer think a wee bit? The liquidity issue is potentially a very serious one.

In short, if you have not changed your asset allocation model over years, you have changed because the fundamentals are radically different!

The second question is about the asset classes. In days gone by, it was simple. Forty years ago, the bond and equity markets WERE pretty much the market, plus, of course property. Derivatives were unheard of and commodities were for the use of.

Stocks and bonds had different behaviours at a global level. They also had different behaviour at a local level. This meant that stocks were employed aggressively and bonds defensively (simplistically). For the clever analytical types, money could be made by exploiting price differences between markets. Arbitrage is now a forgotten art as technology has created one huge global market. Long Term Capital Management failed stupendously, maintaining the belief that arbitrage opportunities continued to exist approaching the millennium. That said, equity smart beta attempts to address the inefficiencies created by market cap weighted indices and so is a form of arbitrage, I suppose. Plus c’est la même chose!

This brings me to what we mean by the term ‘market’. This implies a nice big town square where all stock is available for buying and selling at the stalls. But what about the unregulated over-the-counter market (OTC)? In 2008 approximately 16 percent of all U.S. stock trades were “off-exchange trading”; by April 2014 that number had increased to some forty percent.

In terms of asset classes, we are basically talking about stock, bonds and derivatives. I separate out derivatives as they can have utterly different behaviours to the stock and bonds they relate to. The derivative market has been quoted at $1.2 quadrillion. It is 20 times the size of the world domestic product. Don’t ask me how big a quadrillion is!

Without even considering less traded asset classes such as commodities, one should remember that there is some $75 trillion in cash (M3). If all of the World’s property could be placed in a market, it would have a value in excess of $200 trillion.

So, when someone says they do not make asset allocation decisions because they invest in the World’s market, please ask them how they do it. I’d love to know. The quoted market for stocks and bonds is a tiny proportion of global wealth.

So sadly, we can access a tiny proportion of all markets. The super rich do not need to trade in them. They can do their deals before we know there are deals to be done. Oh, did I forget to mention Dark Pools? Silly me. What are they for? To stop you knowing about the trades the big boys are doing.

So, having aired my thoughts, largely to get a clearer view in my own head, the question appears to be:

Does passive investment mean buying indexed funds because they are cheaper and because active management does not add enough value, or does it mean buying indexed funds AND attempting to employ and neutral asset allocation model?

If it is the latter, I believe the goal is impossible. Whatever asset allocation mix you are selecting, you are making a call on markets – may be a very, very, bad one.




5 thoughts on “Can someone tell me what passive investment means? (and other dumb questions)

  • Clive,

    It is simple for me. We will have a client who needs say 3 – 4 % net return to make their plan work for them.

    I as an adviser need to construct a portfolio that has a high probability over 20 -30 years of providing that return.

    The client has a tolerance to risk which will constrain the amount of risk assets they can comfortably cope with.

    I then mix defensive asset, short term, high quality debt, with a diversified basket of global equities.

    The simple bit is i only need to collect the equity premium to meet my clients goals, preferably in the most diverse way possible and with the least cost.

    The following are irrelevant.

    Using a fund manager with a methodology that seeks to out perform the markets – I don’t need it. Beta is sufficient.

    Deciding on which region I should be in. All of it is safer and again the beta is sufficient.

    Infrastructure, commodities etc etc are all considered to see if they offer anything useful. But hand on heart the equity premium is sufficient.

    Is the market overvalued. Don’t know! Again irrelevant because we are collecting the long term equity premium.

    All I need to understand is which methodology the fund uses to construct the fund portfolio. How does that give me the equity premium without a myriad of unknown probability strategies.

    Passive is a rubbish word used to contrast Active. Both are broad brush descriptions of fund construction methodology. All I need as an adviser is a return that is sufficient to meet the clients need.

    The equity premium is sufficient in almost every case and therefore low cost globally diverse exposure is also sufficient.

    Not much use for an industry with a million and one skinned cats.

  • A very important question and one i tried to answer like this:

    Trying to describe a passive, index or tracker fund is a lot harder than it might seem. Take a look at some excerpts from descriptions, by the managers, of a number of funds that are widely regarded as falling into this category.

    “… closely matching the performance of the FT-SE Actuaries All-Share Index. The Authorised Corporate Director (ACD) will aim to hold securities that represent the FT-SE Actuaries All-Share Index “
    “Generally the Fund intends to purchase a broad and diverse group of readily marketable stocks of United Kingdom companies traded principally….”
    “To closely match the performance of the FTSE1 actuaries All-Share Index on a capital only and total return (after charges) basis.”
    “xxxxx FTSE U.K. All Share Index Unit seeks to track the performance of the index”
    “ aims to provide long term capital growth by matching the return of the FTSE All-Share Index by investing in….””

    And so on.

    Two things stand out. They use words like aim, closely and seek, and they fail to describe exactly how they intend to achieve their objectives.

    It is clear that none of these funds expects to exactly match the index they are tracking. That is because of factors such as new issues, takeovers and holding un-invested cash or perhaps lack of liquidity with some of the small stocks near the bottom of their respective indices. These complexities mean that the managers must exercise at least a modest degree of subjectivity to address these points and maybe use derivatives to help out.

    More important though is how these funds are managed. It is clearly not the case that they just buy the index and leave the market to do the rest. At the heart of this matter is the differentiation between the process and the measure. The process is to invest using a set of rules that could be interpreted by any qualified finance professional, rather than a feeling in someone’s water. That is the passive investing process.

    Since it started in the mid-seventies the default assumption is that passive means allocating capital according to the market capitalisation (mkt cap) of a company in relation to that of the index as a whole. In other words the measure used to allocate capital to a company in the index is the price of that company. This made sense in the early days of indexing when company accounts were rudimentary by today’s standards. Modern financial statements are far more detailed and enable analysts to get a much more thorough understanding of the company. Even so there are essentially only four ways to fundamentally measure the size of a company; by sales, by book value, by dividends and by profits.

    Some argue that weighting based on mkt cap is the only true way to run a passive fund because it uses the same measure as the index and is therefore the only mechanism that permits fluctuations in the market to be reflected in the fund without any dealing activity. Managers who advocate using other measures would counter that this confuses the process with the measure.

    Investors might wonder why there is a need to use any measure other than mkt cap for a passive fund. After all a passive fund will hold all, or virtually all of an index. The question is in what proportion? Here, Oscar Wilde’s famous quip that “nowadays people know the price of everything and the value of nothing” seems relevant to mkt cap based funds.

    Using a value-based fundamental, rather than a price-based, measure to allocate capital does not invalidate the passive process and, arguably, provides the only possibility for a truly passive approach to beat the market. It just does it in a different way. It is perfectly possible to allocate capital by any one of these five measures in a passive manner i.e. following a strict rules based process. There is plenty of evidence, from Warren Buffet downwards, to tell us that portfolios with a bias to value do better over the long terms. That makes sense as essentially managers are investing in anticipation of a stream of earnings and, as with everything in life, buying something cheaply usually gives a better return on that capital.

    A passive fund is simply one that follows a process, however it is defined and irrespective of the measure employed, to invest in all, or the majority, of the constituents of an index with the absolute minimum amount of subjectivity.

  • This highlights the need to outsource investment decisions to free advisers up to do the things we are qualified to do is. Provide advice.

  • It’s always puzzled me why so much time gets devoted to such an unimportant subject and why people get so animated about it.

    Of course you cant do passive asset allocation.

    You cant invest passively in some asset classes (shares and property etc)

    In those asset classes where you can use index or quant funds, the passive approach reduces the risk of manager underperformance.

    Choosing a fund is one of the easier, and less important jobs we do. There are lots of people out there who may make money by pretending otherwise (including those who want you to outsource investment decisions to them!).

  • Perhaps we should simply stop pretending we have or that we know someone (DFM ? ) who thinks they have a mechanism for predicting the future.

    There is not a shred of evidence that people within our industry managing money do anything other than follow markets as they go up and as they go down.

    Timing only becomes relevant when your client wants their money when markets are inconveniently down..

    Our tiny bit of the financial world accounts for a very very tiny bit of the market and our actions have no effect at all on market behaviour and we should perhaps stop deluding ourselves with daft theories and our clients with silly words.

    We are living in an era of zero inflation coupled with zero interest, where we have not been before and historical stuff about correlation has become meaningless.

    No one knows what will happen next to the World’s economies as we can all seee from the endless speculation on the possible timing of interets rate rises.

    You can only be thorough in your research to establish what is actually making money now and try to make sure that your clients are sharing in that experience.

    If you avoid fear and greed in your proposition you might just end up with clients believing that you can after all be trusted with their money.

    Sorry for the rant but watching the FOS giving away my hard earned money to compensate for the actions of advisers pretending to have Crystal Balls ( ? ) has made for a poor start to the day.


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