Passive Investing: Common Misconceptions

by: Nigel Stevenson, CFA


Passive investing continues to divide opinion.

Closet trackers should eventually be squeezed out of the market.

Market may polarize between genuinely active funds and low-cost trackers.

A number of misconceptions still exist about passive investing.

The arguments for and against active and passive investment continue unabated. Even Warren Buffett has come out in support of index funds in Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) latest letter to shareholders. A recent article in the Financial Times, Active management industry in bafflingly good health, by newspaper's Senior Investment Columnist, John Authers, discusses the potential impact of the growth in passive investing. The article makes some interesting points, but also illustrates a number of common misconceptions.

The article suggests that the fund management industry may become increasingly polarized between low-cost index trackers and active funds, which are genuinely active, rather than just closet index trackers. Academic research in recent years (see an article by Petajisto in the Financial Analysts Journal) suggests that funds with a high active share, a statistic that measures the percentage of the portfolio that differs from the benchmark, stand a good chance of outperforming, even after deducting expenses. In contrast, closet trackers, funds that purport to be actively managed, but largely track the benchmark, have historically underperformed by a substantial margin, due to their expenses, which are generally much higher than for a genuine tracker. Logically, such funds should eventually be squeezed out of the market.

Despite the clear benefits of low-cost index trackers for many investors, some people seem to have a lingering feeling that they should be able to do better than the "average" return that such funds deliver. Trackers are almost guaranteed to underperform their benchmark by a small amount, equivalent to their expenses. However, investing inevitably involves some expenses; the index is after all just a benchmark.

There still appear to be significant misunderstandings about the nature of passive investing. For example, the Financial Times article states:

Further, as more money goes to passive funds, which meekly buy stocks at whatever valuation the market is offering, then markets grow less efficient. Indexers tend to be pro-cyclical, or keep trends going longer. As a stock rises, index funds must buy more of it. That increases the opportunities for being counter-cyclical.

First, to criticize passive investing because it sometimes results in buying overvalued stocks contains circular logic. It suggests that it is relatively easy to spot overvalued stocks, when the evidence shows that this is not the case. The benefits of value investing are well known, but it requires considerable discipline to implement successfully.

Second, it is not at all clear that the increased popularity of tracker funds will lead to a reduction in market efficiency. Logically, of course, if all investors adopt a passive approach, the market would cease to be efficient-in theory, the market should be just inefficient enough to make the costs and effort of active investment worthwhile. If money currently invested in closet trackers were shifted to low-cost tracker funds, given closet trackers' tendency to hug the index, it may not materially reduce market efficiency, provided a significant number of genuinely active investors-whether hedge fund managers, mutual fund managers or other investors-remain.

Third, the suggestion that as a particular stock rises, index funds must buy more of it is incorrect; this seems to be a common misconception. If I invest $1,000 in a tracker fund, in which company A has a 1% weighting, my holding in A is worth $10. If A's share price doubles, the weighting would increase to around 2%; the value of my holding is now worth $20, so my holding is also around 2%. It does not need to be topped up by buying additional stock. This after all is the whole point of passive investing. This observation may appear trivial, but it is an important distinction. Passive investors are not trend chasing. Clearly, investors putting new money into the market invest at the prevailing market price, but for those who are already invested this is not the case.

Similarly, the idea that passive investing is pro-cyclical, and contributes to stock mispricing, is also not true. Additional funds invested in index trackers are spread across stocks in proportion to their current market caps: increased investment in trackers pushes up demand for all stocks equally. Their passive nature means they merely reflect the "consensus" view of active investors. At an individual stock level, trackers may not contribute to the correction of mispricings, but they do not cause them, nor do they make them worse.

The final misconception is that quick-witted active managers can somehow make money from mindless trackers. The addition and deletion of stocks from an index like the S&P500 may provide limited opportunities to profit from the mechanical purchase or sale of stocks by funds tracking that index-although this does not apply to funds tracking the whole market-but, in aggregate, it will not increase the opportunities for active investors. Ignoring costs, investing is a zero sum game-successful active investors will only be able to outperform at the expense of other, less successful active investors. In general, they will not make money at the expense of passive investors, even if markets become less efficient.

The opportunities for good active managers may increase if market efficiency decreases, while poor managers may not be saved to the same degree by efficient pricing. As is the case now, underperformers (whether due to lack of skill or simply bad luck) would lose assets to better performing managers, or trackers. Logically, any increased opportunities from the reduction in market efficiency should be quickly competed away. Therefore, even if low-cost trackers are more widely used, it is unlikely to become any easier to outperform in the future than it is now.

Ultimately, active investors will need to have a clear view of how, and from which other active investors, they are making money, and whether the additional costs involved are justified. While I think there are ways to consistently outperform the market, primarily through a long-term, value approach, for many investors passive index trackers are a good choice. Investors should think carefully before choosing active management. In making a choice, it helps to have a clear understanding of how passive and active investors interact.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.