Passive Investing - Myth and Marketing Tale?

Observant1

I just stumbled across the following article from 2014 which cited Professor Snowball.
Link

WSJ: Active or passive? Do today’s fund managers face an insurmountable challenge in beating quantitative systems?

MR. SNOWBALL: “Passive” doesn’t exist. The closest we come to it is Voya Corporate Leaders Trust (LEXCX). Otherwise, it’s a fantasy woven by marketers and advisers. Index funds represent portfolios of stocks selected by flawed, conflicted and occasionally dunderheaded human beings. The Dow and S&P 500 are both good examples of portfolio by committee.

I suspect a better dichotomy is this: disciplined, cost-effective portfolios versus undisciplined, cost-maximizing ones. Many but not all passive products fall in the former. Many but not all active products fall in the latter. Those observations underlie our conclusion that 80% of all funds, active and passive, could vanish without any loss to anyone other than their sponsors.


I agree with the Professor's conclusion that 80% of all funds could disappear
without any loss to investors but think the actual percentage may be even higher.

yogibearbull

LEXCX is a bad example/ideal. It charges 0.51% (about $4 million/yr) to do absolutely nothing for an almost forever-static portfolio of 19 holdings. It's unbelievable that this has been going on since 1935 and the fund still has AUM of $794.2 million.

Indexing, as it has come to be known today, means a portfolio that is based on some prescription or formula and that portfolio is rebalanced/adjusted periodically (monthly, quarterly, semiannually or annually). Rebalancing itself can be all at once (e.g Russell indexes) or gradually, over time (e.g CRSP indexes). Adjustments to take care of daily inflows/outflows don't count. Passive is just a descriptor and probably not a good one.

Active on the other hand is something that makes frequent portfolio changes, even daily.

Factor-based (non-market-cap) funds use some customized indexes and some call them semi-passive or semi-active. That also leads to endless arguments between the likes of Vanguard vs WisdomTree and Research Affiliates (RAFI indexes). As we know, Vanguard finally jumped late into factor-investing after hiring some people from RA.

Costs are another matter. We have low and high cost active funds AND passive funds. iShares has both high AND low cost index ETFs and has justified them on their different liquidity characteristics. For marketing/PR, iShares called the latter newer ETFs core/retail versions but some of those are now larger than the older expensive and supposedly institutional ones (after a while, the institutions saw the light).

A modern debate is whether the recent hot trend of direct-indexing should be called indexing at all. After all, it allows user tinkering, tax-loss harvesting (TLH), etc, in addition to periodic rebalancing.

msf

CIted WSJ column: https://www.wsj.com/articles/mutual-funds-professor-is-blunt-with-the-criticism-1415048456

Indexing as in index funds or as in constructing a market (or segment) index?

Total market index funds typically sample and I suspect make corrective/tracking portfolio changes daily, beyond managing cash flows. If making non-periodic changes is a disqualifying attribute, then ISTM that index funds that sample are likely disqualified as passive funds. And that doesn't seem right.

I prefer to consider index funds those funds that purport to track a third party benchmark. (In this I am somewhat echoing the SEC's description.) This begs the question: is that benchmark a "true" index?

I agree with Prof. Snowball that the S&P "indexes" are not indexes, because they do not follow a formula; securities can be removed somewhat arbitrarily (see below) so long as a human committee perceives that the securities are no longer "representative".

A related reason why I don't consider the S&P "indexes" to be indexes follows from the SEC's description of an index as something that "measures the performance of a 'basket' of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy." A key attribute is that the measurement is path-independent. That is, it doesn't matter how we got to this point, a market's performance is well defined.

In contrast, the S&P committee says that it will not necessarily remove a security from an index even if it would not have included it were it to construct the index from scratch. That's path-dependence. It matters how we got here. The index doesn't necessarily provide an accurate measurement of its market.

it is important to reiterate that just because a given stock might not represent its Index well does not mean that it will definitely be removed from that Index, just that the potential exists. We go back to the definition above and ask ourselves, “If we were starting this Index afresh today, would this company be a member?” If the answer is no, the stock would seriously be considered as a removal candidate.

https://www.evidenceinvestor.com/wp-content/uploads/2016/08/General-Criteria-for-SP-U.S.-Index-Membership-Roger-Bos-Michele-Ruotolo-September-2000.pdf

About the time S&P wrote that paper, it was busy removing several old economy stocks from the S&P 500 for "lack of representation" and replacing them with new economy stocks. The resulting underperformance was overwhelming.
https://www.hussmanfunds.com/rsi/misfitstocks.htm

With respect to LEXCX - passive, yes; index, no (what is it benchmarking aside from itself?). Somewhat similar to HOLDRs - gone, unlamented, in 2011.

Devo

As a group, we investors spend too much time investigating products, and not enough time understanding our own needs and risk appetite. Simple and proven passive products are fine. Don't get confused in all the unnecessary arguments.

rforno

Frankly, I can't stand how passive has come to imply indexing in most people's minds and the media.

In my mind, I'm a mostly passive investor - I do my research, periodically buy/sell things as desired and at a good price/ER and otherwise hold my positions for a very, very, very long time.

Devo

I think that's the way to do it. Somewhere along the line we lost track of the true purpose of all this is to make money and not be religious.

yogibearbull

Some pairs just stick:
Active-passive, when active-index may be better
Growth-value, when growth-cyclicals may be better