Passive Investing - Myth Or Reality? Part 1

by: S&P Dow Jones Indices

By Koel Ghosh

Indexing is certainly not a myth, and while active investing is a popular reality in Indian markets, we are seeing the slow and steady rise of indexed products. In a recent article, John C. Bogle, the founder of Vanguard Group, said, "We are in the middle of a revolution led by indexing" [1]. John C. Bogle's first index fund was launched in 1976, and Vanguard is among today's top global ETF providers.

Revolution indeed. When we see the global ETF assets at over USD 3 trillion, there is no doubt that this space has seen exponential growth. However, there is no argument against the fact that active management can be successful. Advocates of active management argue the ability to outperform benchmarks is what supports their claim on the supremacy of the active play.

However, the question is not whether active management is successful, but rather for how long it is persistently successful. So first, let's review the outperformance of benchmarks. This brings us to review whether the appropriate benchmark is being followed. "Appropriate" is an important qualifier - among other things, it means that the benchmark should be consistent with the manager's portfolio selection style.

To explain this further, a thematic investment portfolio (e.g., for a dividend fund) should ideally be compared to a dividend index rather than a generic market benchmark like the S&P BSE SENSEX or the S&P BSE 200. This ensures that there is an apples-to-apples comparison. This also ensures that market participants are comparing similar universes; hence the "appropriate" comparison.

In the passive world, since the market participants own a proportionate slice of the index, they are earning the index returns less fees and expenses. In other words, the investment and its objective are aligned directly with the index. There should be no subjectivity or doubt as to how the index and its benchmark are aligned.

Hence, the first step to ensure that we are measuring active performance appropriately is to check if the investment strategy or product is appropriately benchmarked. That then provides us with the "real" picture.

[1] ET, Bloomberg, Nov. 25, 2016.

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