Tuesday, July 15, 2014
Friday, July 04, 2014
image: Wikimedia commons (link).
Over the course of three decades in the professional investment business, we've heard our share of arguments for so-called "passive investing," the idea that investing in securities designed to mimic the broader market represents the safest, least expensive, and most certain way to achieve the best possible investment outcomes for the largest number of people. But is there really such an animal as "passive investment" at all? Our opinion on the subject is similar to our opinion on the existence of Bigfoot: we agree that there are many people who claim to have seen such a creature, and we remain open to seeing the evidence, but so far we have not seen enough evidence to believe in the existence of either one (Sasquatch or "passive investing").
The arguments in favor of passive investment are almost always coupled with equally passionate criticisms of "active management" (actively selecting investments in an attempt to provide a better return than the broader market). These arguments usually center around cost (active managers charge more than passive investing vehicles), performance (the allegation that the majority of actively-managed investment vehicles fail to achieve the performance of the broader market over time), theoretical soundness (many passive investment advocates believe that it has been academically proven that it is impossible to beat the performance of the broader market over time, due to the efficient market hypothesis in one of its three main variants), and motive (because passive investment advocates believe that it is almost certainly impossible to beat the performance of the market, they often attribute nefarious motives to anyone who continues to try to do so, usually involving the desire to make money at the expense of all the poor suckers who have not yet accepted the dogma of the passive investing evangelists).
Occasionally, the commitment of active investment practitioners to ideals such as human freedom and self-determination are even called into question, such as in the inflammatory arguments of Rex Sinquefield, who in a debate on the subject argued that "only the North Koreans, the Cubans, and active investment managers" have failed to accept the premise that "markets work." Sinquefield thus equates faith in the system of free enterprise with the belief that no one within a free enterprise system should evaluate individual businesses within that system prior to investing capital in those businesses: unless you give money equally to all the businesses in the market, you might as well go take up residence in Cuba or North Korea. This strikes us as a singularly nonsensical assertion.
We have written on this subject many times in the past, in previous essays such as the one linked above in which we quote Mr. Sinquefield and demonstrate that his arguments are incorrect (see "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital"), and in other examinations of the issue including "The active vs. passive debate," "The emperor's new index fund," and "S&P takes aim at active management."
In those previous writings, we argue that we put more faith in individual businesses (which can be analyzed for their soundness and their business prospects using methodologies which have been developed over the course of nearly a century), than in "markets" (which cannot), and give sound reasons why investors should as well. Today, however, we are going to take a step back in order to question whether "passive investment" exists at all.
Passive investment is defined by Burton Malkiel in his book A Random Walk Down Wall Street (first published in 1973) as "simply buying and holding an index fund" (9th edition, page 345). But what is "an index fund"? The term is broad enough to include securities which are structured as an open-end mutual fund (the first and still most well-known index funds took this form) as well as exchange-traded funds (which can be traded like stocks through brokers for commissions, can be sold short, and avoid some of the tax drawbacks inherent in the open-end mutual fund structure). However, in either case, the term refers to a portfolio which has been assembled by someone (we won't call that someone a "manager" in order to avoid offending the passivists) in order to replicate the performance of some segment of the securities trading in a market.
But an index itself is a portfolio, and it is assembled based on a variety of criteria. If you want to be a passive investor in equities, then you can choose from funds designed to track the venerable S&P 500 (descended from the first cap-weighted index created in 1923), a plethora of other S&P indexes (such as the S&P Composite 1500, the S&P MidCap 400, and the S&P SmallCap 600), the Dow Jones Total Market Index, the various Russell and Wilshire indexes, the MSCI equity benchmarks, and hundreds of others -- just to name some associated with US equities.
Because there are actually over 10,000 publicly traded companies in the US equity markets alone, each one of these indexes which contain fewer than that number of securities is actually a portfolio, constructed by some manager, according to some criteria with actual decisions being made regarding what to do when new companies enter the overall market (when Facebook went public in May of 2012, for example, it took some time before the name was finally added to the portfolio of companies included in the S&P 500, near the end of December, 2013).* Each one consists of a list of securities and a weighting of the securities on the list -- which is the definition of a portfolio (just like the lists created by active managers, who may use different criteria but are doing the exact same thing). There have been literally thousands of such indexes (that is to say, portfolios) created as the "passive" craze has gathered steam, just as any market tends to fill up with various products designed to offer consumers choices and to compete for their dollar.
So, passive investors are using portfolio managers just like anyone else who decides to outsource the selection of the securities they buy instead of selecting those securities themselves. We don't think there's anything wrong with this (after all, we also create portfolios for those who have decided that they themselves don't want to select the securities in which to invest). We happen to believe that there are other criteria by which securities can be best selected for inclusion in a portfolio in addition to those typically utilized by those who construct portfolios that they call "indexes" (for example, we evaluate various aspects of the management team, and various aspects of the potential for future growth in the company's market, neither of which are typically evaluated by those who construct indexes), but they are obviously using criteria to decide what gets into their portfolios just as we are (otherwise, why did it take Facebook over a year to gain access to the S&P 500, and why do different indexes created by different companies such as Russell or Wilshire contain different names from those created by Standard & Poors or Morgan Stanley?).*
We believe that the criteria we use to assemble a portfolio are valid criteria which have stood the test of time and which have produced valuable results for investors in those portfolios -- better results, in fact, than were obtained by investors in most other portfolios assembled by other criteria (whether those portfolios were labeled "active" or "passive" or some other label). But, we don't bash the professionals who are assembling portfolios using methodologies other than our own, and we certainly don't label them "communists" or "crooks" or the other unfortunate sobriquets sometimes employed in this debate.
If they want to label what they do "passive," that's their own choice and their own marketing strategy, but investors should consider how accurate that label really is. Nowadays, investors following a so-called "passive" strategy actually have two or more layers of management that could arguably qualify as "active."
First, of course, there is the active management of those who are assembling the indexes themselves: who are deciding upon the criteria, and then -- when new companies such as Facebook enter the market -- are deciding whether and when to add those companies to their list or not. Because the markets are always changing, with new companies issuing new securities (and new debt instruments, in the case of bond indexes, etc), this is a constant process, and one which could very well be classified as active to some degree.
Second, there is evaluation which takes place at the "securitization" level, in which financial services firms create the open-end mutual funds or the Exchange Traded Funds (ETFs) which investors can actually buy and sell through a broker-dealer or an investment advisor. Here again, some level of management must take place on a fairly constant basis (you can label it "active" or "passive" if you want, but it is obviously a full-time job for a lot of people). Creating these vehicles involves choices as to how many of the names in the index being tracked will actually be included in the investment vehicle (giving rise to greater or lesser levels of something called "tracking error"). When changes are made in the list that is the index, the curators of these vehicles must decide whether or not to include those changes in their own securities, and if so, when and how to make those changes.
Then there is the level of management involved in selecting a mix of securities appropriate to a particular investor, whether that investor is an individual, a family, or an institution such as a foundation, a university, or a state employees' pension and retirement fund. This mix of securities will be based to some degree upon goals, timelines, and a philosophy about the best mix of investments to reach those goals, just as with any other investment. If an individual or family decides to make those decisions for themselves, then they are acting as their own "advisor" in that case, while still hiring the two levels of advisors already mentioned. Nowadays, however, there are a whole host of advisory companies offering their services in the arena of constructing a portfolio of "passive" investments best suited to an individual or family's goals, timelines, and risk tolerances (and at the institutional level, nearly 100% of these decisions have been delegated to a professional class of investment advisors for decades).
We call this level the "intermediaries," because they stand between the end-investor (the individual or family or institutional client) and the portfolio manager. In this case, the portfolio management is split between two groups -- the big firms such as Standard & Poor's and Russell which make the index lists themselves, and the firms that assemble the index funds or ETFs designed to mimic the lists created by S&P or Russell, and who make decisions at their own level about which securities on the list will get into the ETF or open-end fund that they are managing.
Again, we're not saying that there is anything inherently wrong with this set-up, although in practice there can be problems if the intermediaries frequently change strategies in mid-flight. However, we believe it is disingenuous to paint such services as qualitatively different from the rest of the investment advisory world, and to paint those services as somehow more "pure" and "wholesome" because the portfolios and securities selected use "index-style" criteria rather than "business-style" criteria (and to cast aspersions upon anyone who selects securities based on business-related criteria). It is true that such service providers typically charge lower fees than those managing securities based on business evaluations, but they are usually trying to make up in volume what they give away with lower fees. They are not working for free (nor do we argue that they should be, since they are performing services which their clients find valuable and are willing to pay for). However, this is just another argument which shows that their activities are not "passive," since true passivity would imply a lack of activity and a hence a lack of any fee.
In addition, most of these "intermediary" advisory services also perform rebalancing activities, after they are finished with their initial "portfolio assembly" activities. We would argue that there really is no way to characterize rebalancing decisions as passive. Rebalancing necessarily involves a host of "active"-type questions, such as: When do we rebalance? Based upon what criteria? How "out-of-tolerance" must a position in a portfolio become before it warrants trades designed to bring it back in line with the general model weight? These are all decisions over which different managers could debate with various merits, and whose answers will differentiate the management style of one manager from another.
In short, "passive" investing is really a myth, or an illusion, or a marketing ploy which enables some financial services professionals to say, "I'm passive, but I get to change what names I own when I decide to do so (just like an active manager), and I get to decide when to buy and sell and how much to buy and sell (just like an active manager), and -- while I'm at it -- I get to act as though I'm the only type of financial services firm that actually looks out for my clients' best interests, and that no one can expect better results than the results that I give my clients, regardless of what criteria they choose for doing the same things that I'm doing. After all, I have the "academics" on my side!" Some of these "passive" intermediaries make their initial portfolio-assembly or ongoing rebalancing decisions using algorithms or computer models that they have created, but this does not make them any more "passive" than a hedge fund whose managers have created an algorithm to automate buy and sell decisions based on their own goals and timelines and market changes and events.
The comeback from those who are convinced of the inherent superiority of the indexing model to all of this, of course, will be to say that with their lower fees and with the bad track record of most openly-active managers, their portfolio-management, portfolio-assembly, and portfolio-rebalancing criteria are the best for the largest number of clients. We would challenge that assertion, but even if we grant it temporarily, we would say "Fine -- you can say that if you want to, but don't pretend that you're offering something that is quote-unquote 'passive': there is no such animal."
Further, we would argue that the bad track record of "the average mutual fund" (which advocates of index investing are so quick to point out in their marketing material) is primarily due to the fact that most mutual funds tend to invest in "markets" rather than "businesses," which we believe is not the best recipe for success (at least for their investors). Essentially, the typical mutual fund has become so large that it simply is the market! We have often said that if this is the real problem with most mutual-fund investment records, the solution is not to run away from selection by business criteria altogether (which "passive" or index investing advocates do almost by definition).
In the end, it comes down to a question of what investment philosophy you believe is best for selecting investments. There are different beliefs on this subject, just like with anything else, and labels can be helpful in making distinctions between different philosophies. Investors should realize, however, that the "passive" label is misleading -- and it is by no means clear that the philosophy of investing associated with this label is the best way to select companies in which to invest.
We intend to publish a series of future articles exploring this topic further.
* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB). Had they outsourced their portfolio management to the creators of index lists such as the S&P 500, however, they would have been forced to own it. At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Morgan Stanley (MS).