Is passive passé?
Passive investment in equities is often seen as synonymous with indexation, a ‘low risk’ approach to investment that also has the advantage of low fees. However, a little knowledge can be a dangerous thing and nowhere is this morew true than in the world of investment.
During the TMT boom, companies such as Vodafone soared to dizzy heights despite failing to produce a positive return for the passive investors who sought to maintain their index weightings through Vodafone’s foreign acquisition spree. Many UK pension schemes would have had more in that one stock than they had in the whole of another asset class, such as private equity. To have been convinced that ‘risk’ was being minimised in a major segment of a pension scheme’s investment portfolio through having over 10% in
one stock has been a triumph of misplaced dogma over common sense. The minimisation of tracking errors against an index, an objective sought for no reason.
Knowledge does not always equate to wisdom and this holds true for the unfettered use of the two theoretical ideas that lie behind passive equity investment through index funds: first, that investing in the ‘market portfolio’ is the most efficient way of investing and, secondly, the ‘efficient market hypothesis’ that essentially states that share prices are always an accurate reflection of their true value.
James Tobin developed the work of Harry Markowitz on modern portfolio theory in 1958 to show that in an idealised world of borrowing and lending at the same risk free rate, any portfolio on the efficient frontier of maximum return for a set risk can be represented as a combination of the market portfolio plus borrowing or lending. That, however, referred to a portfolio comprising the total investable universe.
If this were restricted to equities, as one enlightened pension manager pointed out: “The challenge is if you go passive then you’ve got to replicate world stock markets and go 50% in US… you don’t want to second-guess the markets, BP is really a US company moaning that their advisers “didn’t really explain the global index properly”.
As the pension manager indicated, a major problem with investing in local indices is that they are often merely a reflection of which international companies happen to be listed in that local market; there is really no reason why BP should a priori have a much larger weighting than Exxon in a UK pension fund’s portfolio. Indexation for specific markets can make sense as we shall see, but as Mike O’Brien of BGI points out: “Indexation has a tarnished reputation in the UK due in part to the concerns about stock concentration and the fact, for example, the top 10 stocks account for over 40% of the index. Indexation seems to be widely acepted at the global level.”
Barry Holman at L&G sees the problem with a local index as the fact that “initially the index was a measure of market performance, then it became a comparison of fund performance and then it became a mandate target”. They see a trend towards core global index mandates combined with active satellites.
Some markets are very efficient and a passive approach to management can make sense, although this may not necessarily imply rigid adherence to a local market index. The US large cap market for example, is one of the most efficient in the world, whilethe same is not true of US small cap where there are many under-researched stocks and an imperfect flow of information that gives an advantage to institutional fund managers over retail investors.
The differentiation between active and passive, indexed management does not always reflect the subtleties of what happens in practise. Seeking passive investment through indexation in a market sub-sector has the problem that an index that seeks to have wide and accurate coverage will need regular rebalancing as stocks pass in and out of the selection criteria. The Russell 2000 US small cap index for example, has had a turnover of over 20% a year and was over 35% in 1999 as stocks passed through the capitalisation sieve. Warren Buffett in contrast has had a passive strategy of buy and hold for decades with an outperformance that is hard to surpass.
This trade-off between minimising tracking error through blind exact replication of an index – despite the market distortions that may be introduced – and pragmatism, becomes a competitive product as ‘enhanced indexation’.
There is a spectrum of activities that can be classed as semi-active approaches that O’Brien argues “seeks targets for added value of perhaps 1-2% for fees of 30-40bp annually and produces some of the highest information ratios”. L&G’s Holman argues that their approach to indexation is also pragmatic, arguing that you “need to be intelligent indexers, minimise dealing costs. Very few people do full replication. We offer low risk enhanced indexation”. This approach has found considerable support in particular markets and as Mark Miller, head of business development at L&G, points out: “Dutch pension schemes are keen on ‘smart passive investment’. We fit quite neatly into that.”
The investment strategy of Dimensional Fund Advisers has gone one step further. Started over 20 years ago, its fundamental premise was the application of indexation to manage small companies, enabling institutions to take advantage of the small company premium in returns that academics were picking up over long time periods.
However, rather than sticking rigorously to the Russell 2000 index, they can hold 3,500 stocks, which comprise the entire Russell 2000 index plus another 1,500 stocks that are smaller in size. “We are not bound by index rebalancing. We can hold companies as they shoot up,” says Garrett Quigley, and this application of a buy and hold strategy through careful trading is one of the key sources of the added alpha that they seek to obtain above the index returns. “We see ourselves as ‘equilibrium managers’ rather than passive.”
Passive management and active are not mutually irreconcilable – they should be combined. The key is to differentiate where one should take on market risk, beta only, and where it is worth looking for above-market returns, by taking on alpha risk.
The first stage in such an holistic approach would be decide on asset allocation taking account of liabilities. One scheme based its strategy on a study by an investment consultant approaching the issue of where to be active and where to be passive, and comments “it showed that in Asia and Japan you should be active whereas in US large cap it’s hard to add value”. In efficient markets, it is worth seeking low fee index or enhanced index approaches if the market returns are seen as attractive – but stock specific risk should be controlled through imposing limits of not more than say 5% in any one stock, irrespective of market capitalisation.
While individual mandates can then be parcelled out to active managers, as O’Brien finds: “Index managers are increasingly being appointed for swing mandates and becoming responsible for maintaining the plan’s overall target for asset allocation across all mandates. At its simplest, every month each manager gives the value of their portfolios and allocations. The swing manager gets two-tier mandates to keep total equity/bond split rebalanced and maintain equity exposures across different markets.
This is done by giving the index manager a calculated percentage of the total portfolio to manage covering both equities and bonds. If the equity/bond benchmark changes, rebalancing becomes a moving target, for example, shifting 5% every quarter. You don’t want to go to an active manager and ask them to shift amounts of that order. L&G agrees with Holman: “We have over a hundred clients where we take other assets into account, with a whole variety of changes required.”
Adopting a passive completely indexed approach can also make sense in very inefficient markets where access to fundamental data and analysis is difficult, and locals with superior information may be driving the market in particular stocks. The market in China B shares is a good case in point.
Traded in China’s domestic stock exchanges in Shanghai and Shenzhen, and denominated in US dollars and Hong Kong dollars respectively, these shares were an unsuccessful attempt at developing a new pathway for attracting foreign capital in the sell-off of state enterprises. Their opaqueness, and poor liquidity, meant the market languished, trading as a whole at discounts of up to 70% or more on equivalent shares issued in the domestic A share market.
The China Index Fund was set up in 1998 with the strategy of investing passively through a complete replication strategy of the 100 or so B shares. As Peter Batey, the fund’s chairman, says: “The strength of the concept was seen in 2001 when the share price went up from $12 to over $35 in a few months when the Chinese authorities allowed domestic residents with foreign currency to invest in the B share market.” Foreign investors in the fund were able to benefit from the market re-rating without taking on stock selection risk.
Batey concludes: “B shares are still an isolated backwater of the market that can offer exciting investment opportunities for those interested in the China story.”
While many defined benefit (DB) schemes are looking beyond simple indexation, the same may not be true for defined contribution (DC). As one pension scheme manager explains: “How do you offer good investment choice without a proliferation of managers? What do you do if a manager is under-performing? You can’t force people to change managers… As a consequence, many DC schemes have gone totally indexed so there is no manager bias.”
L&G’s Miller also finds DC attractive, and says: “Our fastest growing area is DC. We have over 750 clients where index funds are the perfect default choice. It makes us one of the largest UK institutional players.”
So, is passive passé? Naïve indexation in local markets dominated by a small number of stocks certainly is passé for any sensible investor. However, pragmatic indexation at a global level for core mandates, in efficient markets, in restricted markets and for DC schemes certainly is not.
The problem lies with finding the selection of high-alpha assets and managers that can go with it.
Alan Briefel and Joseph Mariathasian are with strategy and market consultants StratCom in London