The myth of passive investment

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NOVEMBER 2017 1 The myth of passive investment INES MAO INES.MAO@EDHEC.COM Passive investment has become increasingly popular over the last decades, so that $1.

Active management is not dead, but it is forced to evolve, while the rise of passive investment is changing the way investors approach asset allocation.

1 NOVEMBER The myth of passive investment INES MAO INES.MAO@EDHEC.COM Passive investment has become increasingly popular over the last decades, so that $1.5 trillion has flowed into passive vehicles, while $800 billion left active peers since Active management is not dead, but it is forced to evolve, while the rise of passive investment is changing the way investors approach asset allocation. The following article is a discussion on the advantages of passive, and how the debate over passive vs active is misleading as it is rooted in a misconception of investment. Spotlight 1: What is passive investing? First let s set the record straight about the definition of both passive and active investment management. A passive management strategy consists in identifying an index and creating a market-value weighted portfolio of stocks in the index, so that the return matches the return of the index it replicates. Buy- and-hold strategy goes hand in hand with passive strategy: a long-term bull market allows a buy-and- hold investor (and a passive asset management approach) to get gains. On the other hand, active management strategy attempts to beat the market return on a risk adjusted basis. To quote Dana Anspach, Active investing is like betting on who will win the Super Bowl, while passive investing would be like owning the entire NFL, and thus collecting profits on gross ticket and merchandise sales, regardless of which team wins each year. In the past seven years, passive funds have tripled, with $6.9 trillion under management. However they still manage less than half the amount of active managed funds. Active investing has always been the predominant approach in investment management. However, since the launch of cost-efficient ways of index-tracking such as exchangetraded funds, passive managed funds have sharply increased. According to a report of Bank of America Merrill Lynch, funds run by Vanguard the giant index fund company now own at least 5 percent of 490 of the S&P 500 companies, up from just 115 seven years ago. Soon afterward, a report from Deutsche Bank predicted that half of all assets would be passively managed by 2021.

NOVEMBER 2017 2 Spotlight 2: the roots of the debate A cure-all. This is what passive investing represents to its growing band of proponents.

Why has passive investment become a huge trend in the markets? The main advantage of passive investment is its cheap way to access the market.

2 NOVEMBER Spotlight 2: the roots of the debate A cure-all. This is what passive investing represents to its growing band of proponents. Equity tracker funds, we re told, will rid the financial market of toxic elements and restore it to full health. Bloomberg article, May Why has passive investment become a huge trend in the markets? The main advantage of passive investment is its cheap way to access the market. As it replicates the past performance of a benchmark index, it requires lower fees and taxes than actives ones where there are no guarantees of superior returns. The enthusiasm for passive strategy has also rekindled with this mantra that has been beaten into the brains of investors over the last 20 years: 80% of active managers underperform index funds. Thus, why pay higher fees for risky funds that probably won t outperform the benchmark. The reasoning is justified, yet hastily, but we ll come back to it later to put it in an other perspective. Average proportion = c.a 35% The debate is also very fertile, as passive investment is issuing many concerns: CONCERN 1: PRICE MISLEADING Alongside the rise of passive managed funds, the strategy of buy-to-hold instead of buy-to-sell is spreading on markets, leaving few safe havens and pushing the value of stocks. There is a decrease in the supply of shares to trade, implying bigger price swings. As a result, companies stock prices have become less correlated to their own fundamental performance and more correlated to a company s characteristics. On the graph above, we can see that there has been an increase in the trading of ETFs since 2004, and that the more ETFs are traded, the more the monthly volatility increases. CONCERN 2: PIGGYBACK RIDE Let s consider ourselves as pure passive managers. If a firm announces its IPO, only two options are worth considering: always go along with stock offerings or choose to never do so, but none of these options is desirable. In practice, passive investors avoid this dilemma by relying on active investors to decide whether to subscribe to a new issuance. Active investors play a vital role in financial markets, as they continuously trade on perceived mispricing, thereby ensuring that market prices are informative and that the market is highly liquid. All it takes is a small proportion of active investors for passive managers to be free-riders on their back. CONCERN 3: A RISK CATALYST Passive investment may also lead to adverse selection and moral hazard.

NOVEMBER 2017 3 The trendier passive investing becomes, the more uncritical buying there is going to be, the more difficult to know the real value of a security.

3 NOVEMBER The trendier passive investing becomes, the more uncritical buying there is going to be, the more difficult to know the real value of a security. It could also lead to a situation where companies offer lower-quality paper, as passive encourages less research-intensive. Spotlight 3: Let s crush the myth of passive investing UNDERPERFORMANCE: A BIASED DEBATE 80% of active managed funds underperform index funds on average. This data is true, but the truth ends here. First, the outperformance idea is misconstrued because the real fund return equals the market return minus the fees and the taxes. Because both active and passive investors are seeking the best return and that passive investors are piggyback riding on active ones, the return before taxes and fees is gonna be similar in the long run. The less you pay, the more you earn at the end; simple math but not enough to reflect intelligent asset allocation nor the real market return. Vanguard one of world s biggest index fund, has recently shown that the active share of a fund has no correlation to its performance. Instead, it is the high fees and high taxes incurred that tend to be the best predictor of the underperformance of a fund. Second, passive managed funds outperform the benchmark and their active peers during bull market periods it shouldn t be surprising. Since the market is in a bull market c.a 70% of the time and that active managers do not hold 100% of an index, they are likely to underperform a highly correlated index fund after taxes and fees. However, in case of a bear market, active managed funds generally outperform their passive peers. Because passive managed funds generally do buy-and- hold strategy, they just lock up the risk and face a 100% risk to volatility and losses in case of a downturn on the markets. According to the figure below, more than half of the active bond mutual funds and ETFs beat their median passive peers in most categories over the past 10 years, with 63% of them outperforming over the past 5 years. THE TEMPORAL PROBLEM OF PASSIVE INVESTING In the long run, we are all dead said Keynes. Indeed, individuals are constantly timing their financial decisions because their spending needs require them to be relatively short-term in many of their biggest spending decisions. Thus, buy-and-hold strategy is not consistant with maintaining a realistic risk profile, but some active asset allocations is.

4 NOVEMBER THERE IS NO PASSIVE, BUT DIFFERENT SHADES OF ACTIVE To discuss about passive investment, let s go back to the prime assumption which is markets efficiency. Basically, the EMH states that all relevant information is already priced into the market, making the attempt of beating it futile. When Chicago booth Reporter asked Eugene Fama - Nobel Prize laureate and proponent of indexing, about the EMH hypothesis, he stated that: The question is: for what purposes are they good approximations? As far as I m concerned, they re good approximations for almost every purpose. I don t know any investors who shouldn t act as if markets are efficient. No evidence suggest that markets are either total efficient or inefficient. According to Fama s definition, a financial market can be weak-form efficient, semi-strong-form efficient or strong- form efficient. The thing is that no one knows the basic laws that govern asset markets, so there s a tendency to rely on assumptions and follow each other. If markets were strong-form efficient, why one would spend time to executes quarterly reports or articles about industry trends? But if nobody does this sort of information-processing, how does new information get incorporated in prices? As Joseph Stiglitz and Sanford Grossman pointed out way back in 1975, a perfectly efficient market is an impossibility. The benchmark on which investments are done is actually an output of the industry. How active managers interpret information and what they do of it makes the benchmark. Active managers are the benchmark. Moreover, pure passive is not possible in the long run. In practice, most bond indexes are rebalanced on a monthly basis, requiring both active and passive investors to trade. Indeed, bonds mature, new bonds are issued, and index inclusion and exclusion rules are constantly creating movements in the index, thus on prices and attractiveness of securities. The passive fund created will position the investor poorly at times during economic cycles and therefore requires an element of active reallocation. A purist passive investor doesn t exist. THE IRREGULARITIES OF ACTIVE INVESTING Despite all the arguments in favor of a revision of the underperformance of active managed funds, one has to recognize that active strategies also has its irregularities. We previously the high transaction costs and taxes. There are also behavioral factors and structural reasons. First, there s the failure to stay fully invested in equities. Since active managers don t have a 100% correlation to index nor 100% long-term exposure, failing to stay fully invested hurts more than it helps. Second, behavioral factors are not to be neglected. Lack of consistency has been shown to decrease the overall return: Brown

5 NOVEMBER and Van Harlow examined several thousand mutual funds from 1991 to 2000 and noted that funds that switch styles had much higher expense ratios and much lower returns than funds that maintain more consistent styles. Window dressing effect: It is a well documented fact that portfolio managers try to rearrange their portfolios just prior to reporting dates, selling their losers and buying winners (after the fact). O Neal, in a paper in 2001, presents evidence that window dressing is most prevalent in December and that it does impose a significant cost on mutual funds. ACTIVE INVESTING, A MORAL RESPONSIBILITY? I think the debate passive vs active is actually a debate about the role of investment in general. To quote Benjamin Graham, the market is like a voting machine. Each individual/investor has the opportunity to vote, thus to add an input to the system. Voting can be seen as useless since millions of others vote. This is a case of free-riding: I prefer to stay at home with my family rather than go outside to vote. Yet, most people decide to put effort into voting, because they see this as a moral responsibility in a parliamentary democracy. I think it is the same for the finance industry. An efficient and liquid market would benefit everyone, but can only arise as a result of large-scale active investing. CAN ONE GOES AGAINST THE TREND? According to Brenna Wilson, a trader analyst at HSBC London, passive investment has to be considered as an opportunity rather than a trend to annihilate. In Asia, fast-developing markets are pushing forward the demand for passive managed funds and banks such as HSBC are relying on their long-term local roots to respond to this rising demand. HSBC even implemented a team specialized in passive trading. A bank or a financial institution can not go against this trend, as it is a global and fully justified demand. Just like any other strategy, it has its flaws and advantages. Transforming change into opportunities seems like the last thing to do, as long as the demand lasts for it. Sources: Goldman Sachs Research Team, Financial Times, Pimco, Eugene Fama, Frederic S. Mishkin, Bloomberg Special thanks to Brenna Wilson for her precious opinion and for giving me an insight of HSBC trading division. And to Milos Vulanovic: thank you for your kind advice and your support.

6 NOVEMBER DISCLAIMER About the article This Article has been compiled by the author mentioned above and published by him via the EDHEC Student Finance Club ( Club or ESFC ) platform. The club confirms that the author is an active member at the time this article is published, but emphasizes the fact that opinions and views given by the author in this article are his/her own views. ESFC takes no responsibility for the completeness or correctness of information provided. No investment advice is given with the text above and the reader should not take any financial position based on the information published in this article. The Club recommends extensive research by the reader before investing in any financial asset. General The article may be based on the information extracted from various sources including but not limited to various companies and statistical agencies websites, online portals, third-party research, annual reports etc. No representation or warranty of any kind is or may be made with respect to the accuracy or completeness of, and no representation or warranty should be inferred from, any projections or futuristic statement contained herein or any underlying assumptions. This article may include descriptions, statements, estimates and projections/futuristic statements with respect to current and anticipated performance of the underlying. Such statements, estimates and projections reflect various assumptions and best estimates made by the participants concerning anticipated results, which assumptions and estimates may or may not prove to be accurate or correct. There are no assurances whatsoever that any statements, estimates or projections contained in this article, including without limitation any financial or business projections, accurately present in all material respects the underlying s financial and/or business position as of the respective dates specified and the results of its operations for any respective periods indicated. No copyright or trademark infringement is intended in any form. Copyright EDHEC Student Finance Club

Hitting a turning point

Hitting a turning point JANUARY 2018 1 AUTHORS BEN LUYTEN BEN.LUYTEN@EDHEC.COM At the end of the year, it is always difficult to avoid an avalanche of reports looking back on the performance of the markets during the past 12