Practical analysis for investment professionals
03 November 2015

Alpha Wounds: Passive Management Is Not Passive

Alpha wounds are decisions made by the investment industry that hurt active investment managers. It is my belief that there is still plenty of alpha left to be harvested by discerning research analysts and portfolio managers. So far I have discussed the deleterious effects of managing to, rather than from, a benchmarkpoor evaluative methodologies by investment industry adjuncts; and the poor diversification of the human resources portfolio at active management houses. This month I point out a fact hiding in plain sight: Passive management is not passive.

One of the tremendous and rarely discussed ironies in the active vs. passive debate is that passive management is thought of as the opposite of active management. That is, it is perceived as a ship set adrift in an ocean with no compass heading and no crew. Passengers are on board and left to fend for themselves. I politely disagree.

Passive management is not blind, deaf, or dumb. In fact, for every index and for every fund or exchange-traded fund (ETF) designed to track it, human choice is involved. As I have discussed before in an entirely different context, choices are actions, that is, activity. That is, we are talking about active investing. To be fair, passive investing is not exactly “active” investing. It is really more like “less active” investing. Given a) the consistent inability of active managers to beat benchmarks, and b) the fact that passive investing actually involves active choices, maybe it makes sense to see what the indices are doing right? . . . Right?

Case Study: The S&P 500

Let’s consider one very famous index, the Standard & Poor’s 500. I hope it is indisputable that the S&P 500 is among the best-known indices and hence a proxy for stock market activity in the United States. Is an index fund or ETF that tracks the storied S&P 500 truly passive? Absolutely not. Many do not realize that a small committee at Standard & Poor’s oversees and makes decisions about the index. Specifically:

“S&P Dow Jones U.S. indices are maintained by the U.S. Index Committee. All committee members are full-time professional members of S&P Dow Jones Indices’ staff. The committee meets monthly. At each meeting, the Index Committee reviews pending corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies that are being considered as candidates for addition to an index, and any significant market events. In addition, the Index Committee may revise index policy covering rules for selecting companies, treatment of dividends, share counts or other matters.”

To me this sounds very similar to a description of the activities of an investment committee at an actively managed mutual fund. Yes, there is certainly a demure, passive tone. No doubt. But there are decisions being made here.

Which brings me to my next point.

Perhaps active managers would be wise to examine the nature of the decision criteria made by this committee in order to improve their own results. This is especially true if, like many funds, the S&P 500 is their benchmark. Put another way: What is this committee doing so incredibly right so as to best a majority of those competing against it?

Here are the criteria that the US Index Committee consider:

  • Market capitalization
  • Liquidity
  • Domicile
  • Public float
  • Sector classification
  • Financial viability
  • Treatment of IPOs
  • A list of eligible securities

Additionally, there are criteria for deleting an issue. Some of the above may seem simple on the face of things, but let’s drill a little deeper.

The Hidden Story Inside Market Capitalization

Market capitalization is indicative of some unique characteristics of a business. For example, a large market capitalization is likely the result of a highly successful business with in-demand products, well-established markets, a strong competitive position, that is professionally managed, well capitalized financially, and for which all of these things have been true over a long period of time. Heck, it is also more likely than not that the business pays its shareholders back with share buybacks, or — gasp! — dividends. In other words, large market capitalization is a natural outcome of running a successful business.

The Remedy for the Alpha Wound: Could “active” managers also consider such criteria in conducting fundamental analysis? Could active managers actually roll up their sleeves and engage in some good old-fashioned fundamental analysis?

Low Turnover

Like most indices, the components of the S&P 500 do not change very frequently. A review of the historical data from 2002 through November 2015 shows 69 additions (and, hence, deletions) from the index. That works out to a turnover ratio of just 1.06% [(69 changes ÷ 13 years = 5.31 changes per year on average) ÷ 500]. Compare that with the average turnover ratio of 124.6% in the United States in 2012 (the last year for which data is available), and an average of the major global equity markets of 89%. Is there any possibility of actually understanding the companies in which you have placed your investors’ cash in these circumstances?

Said differently, US investors have 117.5 times the turnover of the S&P 500. Given that most of the trading is likely in S&P 500 stocks, that the turnover of the index is so low, and that active managers have underperformed, does it seem like a possible self-inflicted alpha wound? In the most positive light, this is a trading desk enrichment program.

The Remedy for the Alpha Wound: Could an “active” manager perform better by reducing its turnover?

Diversification

Another possible lesson to be learned from looking at indices is that each of them represents a diversified portfolio within a given context. For the record, I am personally against what I and many others call “deworsification.” Forthcoming research from C. Thomas Howard, CIO of Athena Investment Management, and a brokerage firm I cannot mention quite yet, entitled Why Most Equity Mutual Funds Underperform and How to Identify Those That Outperform, demonstrates that most fund managers are horribly diversified — as in overly so. The researchers estimate that for every one-decile increase, that over-diversification subtracts 13.5 basis points (bps). Also, they estimate that for every one-decile increase in closet-indexing, that performance is negatively affected by a whopping 31.6 bps. So as managers r-squared relative to their benchmark increases, performance decreases.

It is important to remember that originally indices were created not as investment vehicles, but as a way of summarizing the performance of an entire market in one number. No one is likely to have originated the idea of investing in 500 companies. One benefit of being fully invested in each component of the S&P 500 is you end up buying every winner. But you also end up buying every loser. One simple strategy, and I am surprised that it is not deployed more frequently, is to buy the S&P 500 but to conduct fundamental analysis of its components and identify the handful of firms you believe have the highest probability of performing poorly. Then either exclude these from your index-like fund or short them.

The Remedy for the Alpha Wound: Could it be that active managers are hurting alpha by over-diversifying and closet-indexing?

“Passive” Investing Free Passes

Passive investing gets three massive free passes. First, frequently risk-adjusted returns are calculated relative to the benchmark. This means that because benchmarks are both the numerator and the denominator in such calculations, their risk is always cancelled out. This implies that benchmarks have no risk. Clearly this is bogus. What is needed is a neutral way of evaluating risk to which both the benchmark and the active manager are compared.

Second, benchmark returns are always gross of fees. Yet, if you read through the S&P Dow Jones report I referenced above, you get the sense that there is a large team making these decisions. What is the expense of creating and maintaining these indices? Also, the expense of buying and selling the securities from the benchmark is excluded. Yes, the turnover is low, but for a true apples-to-apples comparison, shouldn’t these be included? As a proxy, many investment industry adjuncts evaluate index funds tracking a particular benchmark in order to estimate these expenses. This is clearly fairer to active managers.

The third and likely largest of the free passes handed to passive investors is the massive momentum effects of their “buy lists.” Indices are effectively “buy” lists. For the larger indices this means that there are huge momentum effects embedded into the strategies. So passive investors benefit considerably from non-fundamental factors when their performance is evaluated. To my knowledge, there is no agreed-upon method for how to back these factors out.

In conclusion, passive investing is not truly passive. It is more like less active management. Looked at in this way, it makes obvious certain innate characteristics of smart investing that “passive” investors take advantage of. Maybe active managers could learn a thing or two from these strategies.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/CSA-Archive

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

8 thoughts on “Alpha Wounds: Passive Management Is Not Passive”

  1. You made a great start. Let me suggest some more “Remedies”. First, market cap. Large market cap is a natural outcome of running a successful business – until you realize that it’s Enron, or pretty much any tech company in late 1999. Active managers should be on alert for these extraordinary opportunities to dramatically outperform. Second, momentum investing in large public companies is clearly a failure from an economic perspective. Value investing works, small cap investing works, private equity investing works. Together they are the mirror image of the S&P 500. A bias towards these tilts would contribute more to economic growth than investing in today’s winners. On a related note, ESG and ethical considerations are ignored by passive indices and yet increasingly, many recognize that these are intangible in the short run, yet essential to consider in the long run.

    1. Hi Russell,

      Thank you for taking the time to share your thoughts with the audience. I am not advocating for high market capitalization. I am advocating that active investors examine why their benchmark consistently beats them. Passive benchmarks have people determining criteria for inclusion. Doesn’t it make sense that we try and identify what these winning criteria might be? Thought so. In the case of the S&P 500 market capitalization is one such factor. I am saying that market cap is a byproduct of characteristics about, and performance of, the underlying business. See the list above for those very factors I highlighted. Active managers can assess these characteristics. Was this not clear?

      Also, all criteria/definitions have exceptions…in fact, Kurt Goedel mathematically proved that this would always be the case. More directly, when you ringfence any idea, you are agreeing to exclude factors from your definition. This is the paradoxical nature of definitions. So to highlight exceptions to the rule, such as Enron, is a pretty easy endeavor as all definitions have violations to the rule. Do you have anything more robust to add?

      Also, I agree that momentum is a failure. In fact later in the piece above I argue that momentum effects must be backed out in order to make an apples to apples comparison between active and passive strategies. I say that passive strategies are given a free-pass for the momentum generated. Apologies if this wasn’t better communicated and would appreciate you showing the audience where I advocated for momentum investing.

      Last, regarding ESG factors. Yes, a nice add, and could probably be the basis of another Alpha Wounds piece. Are you aware of any updated – that is, post 2013 – pieces that show ESG’s performance as a strategy or analysis technique versus non-ESG? The last comprehensive research I saw found ESG returns were not significantly different from a passive index. Wouldn’t it be nice if ESG was more than just a hygiene factor?

      Yours, in service,

      Jason

  2. I think I see the origins of some of the misunderstandings. Your focus in your piece is on beating the benchmark. My intent is to suggest that benchmarks are deeply flawed, and ruinous to returns for portfolios that mirror them and direct investments to sectors of the economy that will underperform in the future (large, public, momentum driven). Of course since the index is the index and constitutes the historical record, the impact on real – life wealth creation is forgotten. Ask shareholders of bankrupt companies and industries that have nearly disappeared over the years. A current example of a curious index is the bond benchmark that is full of securities from an issuer who can issue as much as they like. What an odd benchmark against which to compare returns.
    I didn’t mean to suggest that you believe in momentum. Momentum is just another reason from a macro economic perspective to steer away from index investing. Fortunately there are passive index innovations that are eclipsing pure indexation.
    ESG is a curiosity. All of the studies that I have seen, as you suggest, indicate that returns are unaffected – plus or minus. So efficient markets theory seems not to apply when controlling for ESG factors. I am willing to bet that we’ll eventually find that efficient markets theory holds up, and ESG will turn out to be just another version of active management. Another nail in the coffin for passive investing.

    1. Hi Russell,

      Thank you for the perspectives, I believe they add meaningfully to the conversation. Did you happen to see part one of this series which was entitled, “Benchmark tail wags the portfolio management dog?” You may find that useful.

      I am a fan of ESG – in fact I was selected #53 among global execs discussing issues of SRI by an independent organization last year. I believe that ESG’s day is coming. When cash flows are discounted to present value, and the expenses you are modeling occur a decade in the future, then they are going to have minimal effect on valuation. You could certainly increases costs of capital, but when base interest rates are near zero, then any added cost of capital premium added still has a minimal effect on valuation. But as those future values roll forward, and if base rates increase, then I believe purely from a quantitative point of view you will start to see ESG enter into more conversations.

      Yours, in service,

      Jason

  3. Ahmed says:

    I’m a passive manager and I couldn’t agree more.
    Passive does not mean we are blind or absent or anything. On the contrary, we track and create vehicles that are widely known to be ‘smart’ and ‘advantageous’ even in their raw form without any active decisions.

    Our policies generate good results for investors and no one accuses us of channeling revenue to the trading desk. No one accuses us of overconfidence or wild bets either. It’s smoooooth sailing really 🙂

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