Passive Investment – An Unwitting Oxymoron

Some of my favourite examples include: unbiased opinion, deafening silence and bittersweet (to name a few). One oxymoron I have been hearing more recently and which bothers me, however, is ‘passive investment’.

Given that the term ‘investment’ refers to the allocation of one asset for another, often with the sole purpose to generate a return, to describe an investment as passive is somewhat of an oxymoron. To use cash to buy equities is an active investment decision. To move money out of active into passive strategies is not only an ‘active’ allocation, but each day it is left untouched is yet another active allocation. One can only attach a modifier of ‘low-fee investment’ to this active decision.

Market cap index does not represent broad equity market

Aside from my own philosophical bent towards active investing, there is another more compelling reason why I flag this classic oxymoron. It can cloud traditional benchmarking, a central pillar of the investment management industry. It is important to benchmark and monitor the decisions taken by others. In the world of active asset management, more often than not, this is through comparisons with market cap indices. But in reality, market cap indices are not a perfect representation of the broader equity market.

All portfolios, even benchmarks, are a product of their portfolio construction equation. Market cap is a simplistic portfolio construction formula, which is derived from the summation of each company’s shares outstanding multiplied by its share price. This portfolio construction method dictates that price momentum can play a significant role in how this index portfolio performs.

Let’s take a simplistic example using the S&P/ASX 100. If one single stock outperforms the rest of the 99 stocks within this portfolio of 100 holdings by a ratio of two to one, its allocation/weight within the benchmark will rise, while the remaining 99 names will show a modest reduction in portfolio weight. Conversely, were this stock to underperform by half that of the remaining 99 names, its allocation within the 100 name index portfolio would fall. Price momentum, or to be specific, its relative price performance, clearly influences its final allocation and weighting. If the portfolio construction decision is based on price and shares outstanding, it is not too surprising that price momentum plays a significant role in the performance patterns of an index portfolio.

Inappropriate benchmark for a value investor

This can be problematic for index benchmarking as few active equity managers use price momentum as an active philosophy when valuing their investment. While it is true that many use price momentum as a timing indicator, active managers use other metrics in identifying their strategic investment decisions. When assessing active equity managers, is a price momentum portfolio the right benchmark?

I suspect that this is partly why a number of academics have been endorsing ‘smart beta’. Academic Barr Rosenburg long ago stipulated that there were three main factors determining systematic-market returns: size, value and price momentum. Smart beta can now look through a framework of size, value, price momentum and any number of other factors that drive systematic returns.

That much is known, but what is not as widely discussed is the role that momentum plays in market cap indices. A market cap index portfolio could just as easily be deemed a smart beta option towards the price momentum factor. If so, to assess an active manager’s portfolio through a price momentum benchmark could yield misleading conclusions, given that active portfolio managers use other metrics.

This is concerning as decisions about the value-add from active managers are being made on the basis of market cap benchmarks, which at some points in the cycle are heavily skewed towards a single factor (price momentum). In periods when price momentum is driving market returns, intuitively active managers will find it difficult to outperform an index. However, the reverse is also true, when momentum is not a factor driving market returns that is when the active manager should be adding real value.

Move to index introduces price momentum influences

In response to continued market uncertainty, coming at a time when many Baby Boomers are moving towards their drawdown phase, many investors are looking to de-risk their portfolios by seeking ‘passive’ alternatives. But there is no such thing as a passive investment. And while accessing a market cap weighted portfolio does neutralise the risk of relative underperformance from a benchmark, investors do so by embracing price momentum. In highly uncertain markets, price momentum-influenced portfolios add to overall market volatility given market caps ‘buy and hold’ portfolio construction.

Every investment is an active one. Investors must understand the consequences of moving towards market cap weighted, or price momentum beta portfolios. While it is true that fee budgets are lowered, everything comes at a cost in our quest to maximise risk-adjusted net returns. And an investor’s goal should not be minimising cost, but maximizing returns.

Source: www.cuffelinks.com.au
Author: Rob Prugue is Senior Managing Director and Chief Executive Officer at Lazard Asset Management (Asia Pacific). This article is for general education purposes and readers should seek their own professional advice before making any financial decisions.