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Index illusions: why passive investors are active without knowing it

Index illusions: why passive investors are active without knowing it

The argument for passive investing, though popular, has fundamental conceptual flaws. Active investing is unavoidable, including for those who use trackers.

Unlike most endeavours, investing is something that only becomes easier with age, albeit slowly. It is the very epitome of learning by doing. As such, it somewhat goes against the grain of an ever faster-paced modern life, where the aggregation of information is conflated with wisdom and pseudo-scientific theories abound.

Economics, which at its founding was little more than an interesting side shoot of moral philosophy, has burgeoned into a global industry, bolstered by the parallel expansion of investment theory. For if markets could be understood, rationalised, measured and explained, they would be accessible to more people, perhaps more profitable for those who took the time to study, and less dangerous to society at large.

Bang goes the theory

Investment theory is 81 years old if we take its birthday as being the 1934 publication of Benjamin Graham’s book Security Analysis. Since then, it has generated endless discussions, papers and treatises. Yet, as recent events in Shanghai and Shenzhen attest, markets remain as unruly and prone to booms and busts as ever.

In fact, so ill-fitted are markets to scientific thinking that competitor theories have emerged. We are encouraged to consider the random walk of share prices and apply the chaos of nature to markets.

As we struggle to apply concepts to markets, we are repeatedly reminded of the failure of most active management propositions to beat the market. Is this due to deficient theories or inadequate practices?

The passive industry has been bolstered by academics and commentators, who have not been shy to denounce active and have channelled their critique into a thundering business proposition. Assets in the top three largest passive managers, BlackRock, State Street and Vanguard, total in excess of $5 trillion (£3 trillion).

Cost and value conflict

Costs matter, wherever you sit in the investment food chain. However, it is wrong to characterise costs as the guiding principal for investment as adopters of passives often do. In doing so they fuse cost and value, which are two distinct propositions.

Warren Buffett, who is active from the tip of his crown to the toes of his Florsheim penny loafers, famously suggested his wife should be invested in trackers when he was gone.

As proven by this comment, there is no one quite like Buffett. But his investing techniques are not novel in isolation, even if they are remarkable in combination.

Concerns about trackers

I have several concerns about the way in which trackers are being promoted and used. At a conceptual level, I reject the notion that a tracker portfolio is in any way passive.

Choosing indices requires a highly active set of decisions. Recent history relates that a 60%/40% global equity/bond portfolio would have generated an annualised return of 6.8% over 10 years with a volatility of 9.6%. By contrast, a 100% global equity portfolio (MSCI All Country World Index) would have generated a lower annualised return of 6.5%, with volatility of 14.4% over the same period.

I would, however, dispute the very notion that there is a neutral position in an allocation process. The determination of neutral is a subjective judgement.

Beyond that, I would question the assumption of diversification in selecting bonds and equities, and suggest the choice of index, other than a fully representative World index, is also riddled with subjectivities.

Weighting worries

Many passive allocators (who are closet active to my mind) assemble portfolios with reference to world market capitalisation but do not necessarily mirror it accurately. As a consequence, the US may be accorded a heavy weight, a seemingly uncontroversial decision as it has been the world’s strongest capital market for the past 100 years.

There is also a tendency towards home market bias. Of UK managers, the UK portion of the Investment Association (IA) Flexible sector equity allocation is 30%, compared with the ‘neutral’ position of 7% as defined by its weight in the MSCI All Country World Index (see chart below). The IA has further found that the proportion of UK equity mandates of the UK institutional market came to 29% in 2014.

Home bias: managers with flexible mandates tend to invest domestically

Source: Cerno Capital, Morningstar

Safety myth

A host of behavioural observations can be made in relation to the selection of assets that have just performed very well, as market capitalisation weights tend to suggest.

A number of biases are at work here: anchoring (decisions influenced by input that seem to suggest the right answer); availability (reliance on knowledge that is readily available rather than examining other alternatives); confirmation (the tendency to seek and interpret information that confirms existing beliefs); and framing (the fact that a market is rising creates a framework through which economic information is interpreted).

I distrust the apparent safety of so-called passive investing and any suggestion that it results in lower risk. It often results in the removal of cash as an active allocation tool, resulting in higher exposures to risk assets that would otherwise be the case.

I also distrust any process that references a neutral point of view or neutral allocation stance. Trackers have a useful role in an active investment management process. Everything is risk. Risk is everywhere. There is only active.  

James Spence is a managing partner at Cerno Capital

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