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«The dark side of passive investing David Blitz, PhD The dark side of passive investing | 1 The rise of passive investing Passive investing has become ...»

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WHITE PAPER

February 2014

For professional investors

The dark side of

passive investing

David Blitz, PhD

The dark side of passive investing | 1

The rise of passive investing

Passive investing has become increasingly popular over the past

decades. The arguments in favor of passive investing are well-known,

and we acknowledge the validity of these arguments. However, there

are also some considerations which should make investors think

again about the desirability of a passive approach. A discussion of this ‘dark side’ of passive investing is the subject of this note.

Passive investing ranks among the most successful innovations of modern finance. At its foundation is the realization of Sharpe (1991) that active management is a zero-sum game before costs and a negative-sum game after costs. This realization implies that a strategy of simply buying and holding the capitalization-weighted market portfolio at minimal costs should ensure a better performance than most actively managed funds. The proof of this theoretical concept in practice has been provided by passive investment pioneers such as Vanguard. Their success has not gone unnoticed, as the market share of passive managers has risen steadily over time, and many large institutional investors nowadays invest large portions of their assets passively. Even regulators have recently started to openly question active investing, encouraging investors to seriously consider a passive approach instead.1 Passive investing has appeal In this note we are not denying that passive investing is an appealing concept. In fact, we

fully acknowledge that:

• a passive manager is likely to outperform an active manager chosen at random, assuming the latter involves higher fees and costs2;

• passive investing has the benefit of being a highly transparent approach, as performance can be evaluated against an index that is independently calculated by a third party;

• a passive approach can be applied on a large scale because of its high liquidity;

• passive investing may be considered a safe choice, because by pretty much guaranteeing a return close to the index it eliminates the risk of having to explain a large underperformance sooner or later.

Serious concerns However, we also have some serious concerns with regard to passive investing. We argue that if these concerns are also taken into account, the case for passive investing is not so clear-cut anymore. But first we define what we mean exactly with passive investing.

In the Netherlands, for instance, the AFM takes this stance in its white papers “De wetenschap over de resultaten van actief en passief beleggen” and “Leidraad actief en passief beleggen in het belang van de klant”, while the DNB now explicitly penalizes pension funds for using active management, with higher solvency requirements in its FTK regulatory framework.

This is typically the case in practice, although not necessarily so.

–  –  –

A myriad of passive products Given that in theory passive investors just need a single product that replicates the broad capitalization-weighted market portfolio, it is striking that in practice investors can choose from a huge number of different passive products. One can imagine not one but a few products, because of competition from different providers, or practicalities such as time zone differences which frustrate trading in all markets simultaneously. In practice, however, many thousands of passive products are on offer to investors. This raises the question: why so many?

Isn’t it ironic?

In order to answer this question, we need to take a closer look at the characteristics of all these passive products. It turns out that many passive funds follow just a part of the market portfolio, such as a single sector or a single country. As such, these passive funds are typically not used to passively follow the broad market portfolio, but as instruments for active sector and country allocation. This is actually rather ironic, because if there is one form of active management that is particularly tough, it is making active asset allocation decisions. This follows not only from empirical studies, but also from Grinold’s (1989) theoretical Fundamental Law of Active Management, because of the small ‘breadth’, i.e.

the small number of independent decisions, involved in active asset allocation.

Market price distortion Another issue with passive funds in practice is that they typically track a liquid market index, such as the S&P 500, rather than the broad market portfolio containing all listed securities. This approach is known to significantly distort market prices and negatively affect the performance of passive investors. For instance, Petajisto (2011) documents significant price reactions following announcements about stock inclusions and exclusions for popular indices, while Chen, Noronha and Singal (2006) estimate that arbitrage around the time of index changes results in losses between USD 1.0 billion and USD 2.1 billion a year for investors who passively follow the S&P 500 and Russell 2000 indices. In order to ensure a truly passive approach which does not suffer from these shortcomings, investors should consider the most broadly defined capitalization-weighted index.





Smart beta investing is active, not passive

Another group of supposedly passive products are actually active products in disguise:

funds based on so-called ‘smart beta’ indices. Although these funds passively follow an index, this index reflects a mechanical active strategy which intentionally deviates from capitalization weights in order to achieve a superior performance. Examples include fundamental indices and minimum-volatility indices. Although a lot may actually be said in

–  –  –

Having clarified what passive investing is really (or should really be) about, we now turn to our main concerns with passive investing. Our first concern is the free-riding nature of passive investing, and our second concern is that it goes against proven factors. In the following sections we will elaborate on these issues.

The dark side of passive investing | 4 Concern #1: Passive investors are free-riders Lorie and Hamilton (1973) already noted that the market can only be efficient if a large number of investors actually believe it to be inefficient, the so-called efficient markets paradox. In other words, the existence of a large number of active investors is a necessary requirement for efficiently functioning capital markets. Active investors continuously trade on perceived mispricings, thereby ensuring that the price of each security always reflects the market’s best assessment of its (unobservable) true value, and that the market is highly liquid. As such, active investors play a vital role in financial markets. Passive investors, on the other hand, are basically free-riders, as they do not make any attempt to assess the fair value of a security. Instead, they assume that active investors have done their homework properly, which enables them to simply accept and mechanically follow the observed security weights in the capitalization-weighted market portfolio.

Passive investing is impossible without active investors True passive investing is actually impossible, because when a company wants to go public (IPO) or a government wishes to borrow money, investors have to choose whether to participate in this offering or not, which is an active decision. A passive stance could either be to always go along with new stock and bond offerings, or to never do so, but both of these alternatives would clearly be highly undesirable. In practice passive investors avoid this dilemma by relying on active investors to decide on whether to subscribe to new issuance, and simply following in their wake. This example already illustrates that a situation in which everyone would attempt to invest passively is highly undesirable, as requests for new capital by firms and governments always require an active assessment by investors.

Passive investing is not only ill-equipped for dealing with new issuance, but also for securities that are already listed. If everyone would attempt to invest passively, the result would be a breakdown of the link between prices and fundamentals. Liquidity would also disappear, because passive investors do not trade, but simply buy and then hold on to the capitalization-weighted market portfolio. Clearly, not everyone can be a free-rider, and if everyone would try to adopt passive investing, a higher authority such as a government or regulator would probably feel obliged to intervene, e.g. by taxing passive investing, or by banning it altogether.3 Consider the implications This kind of situation may seem like a far stretch from reality. And indeed it is, because even if, say, half of the money in the world were to be invested passively, the market would probably remain quite efficient. But does this mean that, for the time being, passive investing should be encouraged? Or are we perhaps already at the point at which discouraging passive investing would actually be more appropriate? At the very least the We acknowledge that it is unclear if this would actually be feasible in practice. For instance, it is hard to draw a line between a realistic, pragmatic approach towards passive investing versus active investing. In addition, there is also the question of how to deal with hybrid approaches, such as enhanced indexing. However, our observations in this section are not meant as a ready-for-use practical solution, but intended to stimulate a fundamental discussion about the nature of passive investing.

–  –  –

The sustainability dimension of passive investing These considerations might be called the sustainability dimension of passive investing.

Interestingly, investors increasingly demand that the companies they invest in adhere to a sustainable business model, but we argue that the sustainability of their own investment approach ought to be put to at least the same scrutiny.

Active investing: a moral responsibility?

A famous quote from Benjamin Graham is that the market can be compared to a voting machine. This is a useful analogy, because, similarly to passive investing, voting in a parliamentary democracy involves a big free-riding problem: voting is basically futile so long as millions of others vote. Free-riding appears to be a rational alternative: instead of going out to vote, spend the time on a more useful activity, such as family or a hobby.

Interestingly, however, most people are well aware of this logic but still choose to put time and effort into voting, arguably because they see this as a moral responsibility in a parliamentary democracy. In the same spirit, active investing may be seen as a moral responsibility that comes along with a market economy. An efficient and liquid market benefits everyone, but because this can only arise as a result of large-scale active investing, perhaps every investor should feel obliged to contribute.

The dark side of passive investing | 6 Concern #2: Passive investing goes against proven factors Our second concern with passive investing is that it goes against proven factors. The literature provides extensive evidence that securities with certain factor characteristics tend to exhibit a very poor performance, while other characteristics appear to be rewarded with better returns. Because passive investors simply buy the capitalization-weighted market portfolio, which contains all securities, they basically choose to ignore such evidence. In other words, a passive approach involves intentionally investing large parts of one’s portfolio in segments of the market that are known to be associated with disappointing historical performance characteristics.

Diversity in stock characteristics… We illustrate this point by taking a closer look at the equity market portfolio. It is important to realize that this is not a homogeneous group, but consists of stocks with all sorts of characteristics. For instance, it includes stocks with low valuation multiples (value stocks) and stocks with high valuation multiples (growth stocks), stocks with a strong momentum (past winners) and stocks with a weak momentum (past losers), stocks with a low past volatility and stocks with a high past volatility, et cetera. This diversity within the market portfolio is illustrated in Exhibit 1.

Exhibit 1 | Illustration of the diversity of the capitalization-weighted market portfolio

–  –  –

… and in performance The reason for grouping stocks according to these specific factors is because numerous academic studies have documented that these groupings exhibit very different performance characteristics. This is illustrated in the figure below, which depicts their historical risk and return characteristics for the US equity market over the 1963:07period.4 It is clearly visible that value, past winner (momentum) and low-volatility Source: Kenneth French data library and own calculations. The methodology used is similar to Blitz (2012). As the portfolios are based on the large-cap segment of the market, these strategies can be followed on a large scale. The factors discussed are also known to be effective in the small-cap segment of the market. In theory the factor premiums that can be earned here are larger,

–  –  –

Source: Kenneth French, Robeco Proponents of passive investing might argue that these large performance differences arise because of the behavior of active investors5, and that the way to deal with this should therefore be less active and more passive investment. However, this is like a medicine which effectively treats the disease, but kills the patient in the process. Perhaps the value, momentum and low-volatility effects would indeed disappear if everyone would attempt to invest passively, but, as argued in the previous section, in such a world the link between market price and fundamentals breaks down altogether, which is a lot worse still.

Moreover, although passive investing has increased steadily over the past decades, it appears to have had little or no impact on the continued existence of these anomalies.



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