Passive vs Active Investing
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Paul Volcker once quipped that the only useful innovation that emerged from the world of banking and finance in the 90s and 00s was the ATM. I disagree with him! Passive replication emerged during that time too. It has been a defining innovation for investors looking for broad market exposure at low costs and is today one of the key tools in building portfolios. In many cases, these indices perform better than active investment net of fees. So why have long-term investors not replaced active investments with passive investments altogether? Why are the largest and best long-term investors in the world still willing to pay fees for active management if alpha is so elusive? While passive investing does solve a host of problems, it can create others, and several of the most held beliefs about passive replication turn out to be myths rather than reality. For example, adopting a passive approach does not guarantee diversification, it does not guarantee access to underlying macroeconomic growth, and, in some cases, it can be very expensive to implement. Most importantly, the most sophisticated, patient, long-term investors may be leaving money on the table by eschewing active investment, even in liquid markets.
In this newsletter, we will review the advantages and issues with passive investing, and in the process separate the myths from reality.
Passive replication – A revolution of our lifetime
Let’s start with everything that is right about investing via passive replication[1]. Starting from a small share of total invested capital at the turn of the century, passive strategies now represent a significant share of invested capital across different asset classes. Within equities, the AUM of passive funds represent 56% of the global equity fund universe in 2022. For fixed income, the AUM of passive holdings represents 35% of the global fixed income fund universe[2]. This figure partially underestimates the actual importance of passive replication because it excludes institutional investors replicating indexes internally. Chart 1 illustrates this tremendous growth.
Chart 1: Growth of Global Passive Products
From large liquid markets, passive replication has now expanded to more complex strategies: for example, specific industry sectors, specific factors[3], leveraged long or short strategies, or commodities amongst many others, can all be replicated at low management costs. Some of the more alternative ETFs that have emerged recently include:
If the index is well chosen, passive replication achieves an immediate and high degree of diversification.
Passive replication has also expanded because, in many efficient markets, it has delivered better net results than active management. We believe that very few active managers deliver alpha consistently and that even fewer deliver positive alpha after accounting for fees. In the US large cap equities space, less than 5% of managers outperform their benchmarks[4] net of fees. Identifying the few managers who can consistently outperform requires extensive resources and experience, and even when they are identified access is often an issue as they are highly selective with their investors. Most of the investing public has neither the resources to pick these managers nor the ability to access them through an independent third party and therefore should be better off investing passively.
There is a very large number of passive products that can be accessed with limited complexity. They allow investors to build increasingly nuanced portfolios. Even for more complex strategies, passive replication can now be a useful tool and, in some cases, a more powerful tool than active investment. As an illustration, Chart 2 below shows how the broader hedge fund market (as represented by the HFRI FOF Diversified Fund) underperformed a passive replication of the underlying factors since the Great Financial Crisis. As markets become more efficient and specific strategies get crowded out, passive replication slowly but surely eroded the edge of many active managers.
Chart 2: Hedge Funds Fail to Outperform Beta Returns, Net of Fees
Debunking myths about passive replication
If passive replication has become such a ubiquitous and powerful tool, why are some of the most reputed investors in the world still investing behind active strategies? To start with, active management is required to access some asset classes. They include private equity and absolute return strategies[5], which have become the mainstay of many long-term investors’ asset allocation (e.g., in the 40-60%[6] range for most large US universities endowments). In addition, when implementing passive investment strategies, it is important to understand risks that bear on whether it is the best approach for a given strategy and how it needs to be executed. The key issues include portfolio concentration; misalignment between the chosen index or basket and economic value creation; lack of downside protection; and lack of upside. Digging deeper into this requires busting a few myths about passive investing.
Myth #1: Passive replication provides guaranteed diversification
Successful companies tend to dominate many indexes. Over the past 10 years, technology firms have grown tremendously in many markets. In the US, the Magnificent 7[7], some of the largest technology firms, represent over 25% of the market capitalisation of the S&P500. This can be positive: the Magnificent 7 represented nearly 70% of total S&P500 returns as of the end of July 2023. This can however go in reverse and investors who passively follow an index have no control over it. In Korea and Taiwan, the stock market is dominated by two firms, Samsung and TSMC, who represented 34% and 42% of their countries’ MSCI indexes as of July 2023 respectively. Chart 3 illustrates this point.
Chart 3: Concentration of Indices
For any market-cap driven equity index, concentration is driven by past performance and investors are by definition buying into yesterday’s growth stories. This may or may not be an issue. For debt markets, this concentration could be a more significant issue. As debt indices are built on the total outstanding stock of debt, investors concentrate their exposure in the most indebted companies or countries (e.g., Japan’s weighting in global debt indices is over twice its weighting in global equity indices[8]). Similarly, convexity can have perverse consequences on the composition of bond baskets. In the example of a declining interest rate environment, bonds with the lowest yield (i.e., the most expensive ones) will increase in value relatively faster and, perversely, become an even larger share of the basket. This in turn increases the potential downside from a reversal in interest rates. There are techniques to address these issues – for example, creating bespoke indexes or using equal weighting irrelevant of market capitalisation. This can however be quite expensive to implement and create other portfolio issues down the line.
Myth #2: Passive replication provides a reliable proxy to the underlying economic development
In certain markets, tradable indexes may or may not capture ongoing economic value creation. Let’s take Southeast Asia as an example. It has a vibrant economy supported by a young population, the emergence of a middle class and is also seeing sustained improvements in governance, infrastructure, and technology. The MSCI AC ASEAN Index is however dominated by financial services, industrials, and telcos as Chart 4 illustrates. While these may or may not be attractive investments, investors who want to bet behind the growth and transformation of Southeast Asia need to invest away from the index. This means for example seeking a higher exposure to digital transformation or the growth of the middle class in these countries.
Chart 4: MSCI AC ASEAN Index Sector Split
As previously stated, this issue could be overcome by creating a different basket to replicate – e.g., one that includes more economic sectors and is equally weighted. However, the choice of the basket is in itself an active investment decision and just another form of systematic but active investing.
Myth #3: Passive investors can seek downside protection from active management on an ‘as needed' basis
By design, passive investing offers great protection against underperforming a given index. Said differently, it also offers no downside protection. Because of this, one could conclude that passive investing is best adapted to investors with a long-term horizon and small predictable liquidity needs on the assets. For those who cannot afford (or cannot stomach) large, unexpected drawdowns, creating balanced portfolios of passive investments spanning different asset class is possible. For example, investing passively in a balanced equity-bond portfolio, can reduce performance volatility. This is however no guarantee that the passive strategy, once defined, will perform as expected a downturn. The performance of the passive 60-40 equity-bond portfolio declined by over -16% in 2022, illustrating this point. Another approach often suggested is to shift from passive to active when market conditions “suggest” that active management might become beneficial. This is akin to buying car insurance instants before having an accident and inconsistent with the beliefs underpinning passive investing: if you believe it is possible to have such great insights about the future of the market, you should always be investing actively!
Myth #4: Passive is always the cheapest way to invest
There are asset classes where replication is difficult and where it could become surprisingly expensive. Some commodities fall into this category where actually closely tracking the price of a commodity using futures replication is both difficult and much more expensive than for other asset classes. This is especially the case in a trendless market – oil ETFs are a good example as they have historically done a poor job at tracking oil prices because of the cost of “rolling” futures contracts. In Chart 5, we illustrate how investors could significantly underperform the performance of the underlying by investing in ETFs tracking the underlying’s futures.
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Most active strategies that invest in the same commodities would suffer similar issues, but they can be more selective on how they trade the contracts in periods of contango[9] to minimise negative roll yield.
Chart 5: Futures Replication Underperforms Underlying When The market is Trendless or in Contango
Myth #5: Passive systematically outperforms
By design again, passive investing does not allow for upside compared with the market. During the period that extends roughly between the Global Financial Crisis and the post-Covid recovery (most investors’ careers), this has not been a major issue because beta returns were high and above the target of most longer-term investors. In an environment of higher and more volatile inflation, longer-term expected equities market returns are now lower than many investors’ nominal targets. Lack of upside (alpha) becomes a material issue for many investors. Active management gives the potential for outperformance against passive alternatives, especially in volatile markets and in areas requiring specialist knowledge and insights – e.g., technology, biotech, emerging and frontier markets, or small caps. Compounding that outperformance over long periods has profound implications for capital value.
We can illustrate this with an example in the equities market.
Chart 6: Growth of $100, Net of Fees
Investment implications – How to use passive investing in portfolios?
Active management contributes to the portfolio performance when the benefits it generated can outweigh the cost of management several fold. Therefore, the manager selection process becomes critical to identify the managers that can generate net positive alpha on a sustainable basis. As stated above, this includes for example technology, biotech, emerging and frontier markets, or small caps. More generally, this includes many areas where deep knowledge can create asymmetric insights about the valuation and relative valuation of assets.
For everything else, where there are no advantages to active management, a passive replication should be adopted.
[1] Passive replication is a long-term strategy where an investor replicates the performance of a chosen market or mix of markets. ETFs or passive mutual funds attached to indexes such as the S&P500 or the MSCI ACWI are some of the most common ways to achieve this objective.
[2] The global equity fund universe is made up of ETFs, Mutual Funds, and Hedge Funds that invest primarily in equities. The global fixed income fund universe is made up of ETFs, Mutual Funds, and Hedge Funds that invest primarily in fixed income securities.
[3] In this context, a factor refers to a specific characteristic of a portfolio that influences performance and risk. Examples of factors include value, growth, quality, or company size.
[4] Research from S&P Global found that over the 15 years ended 2021, only about 4.5% of professionally managed portfolios in the U.S. were able to consistently outperform their benchmarks.
[5] Some absolute return strategies have started to see ETFs emerge to replicate their strategies, such as merger arbitrage through the “IQ Merger Arbitrage ETF (MNA)” product but these are still in a more experimental phase and are not seen in the mainstream.
[6] Endowment exposures sourced from the latest available financial reports of the largest US universities endowments, where available.
[7] Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms.
[8] Japan’s weighting is 5.5% in MSCI AC World and 12.6% in FTSE World Government Bond Index as of July 2023.
[9] Contango is a futures market occurrence marked by futures contract prices of a commodity being higher than the expected spot price of contract at maturity. ?
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