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.