Passive managers reject criticism [+ WHITE PAPER]

Simon O’Grady, Kiwi Wealth chief investment officer, said passive management was problematic because it had an in-built tendency to buy more and more of the most expensive shares as they rose in value.

“With market conditions becoming increasingly volatile, the risk of a downturn means that passive investors are likely to be carrying higher risk. Of concern is massive inflows of money via passive funds into mega cap stocks.

“Many of these stocks are now quite richly valued and face the added risk of flows drying up, yet passive investors are still buying at a pace.

“Only active managers make an effort to assess the value of stocks and whether they’re worth buying. That’s why we’re constantly deliberating and considering our positions.”

But Dean Anderson, who now heads index investment platform Kernel, said index funds would only invest proportionately to the value of the company and would not drive its value higher.

“Passive is not setting the price every day. The price is being set by the large volume of active trading.”

He said there was also no truth to the idea that passive funds could push prices down by selling out if a stock dropped.

“If we put $1 million in and buy a million units those units just sit there, we don’t buy or sell until there’s an index rebalance and that may happen twice a year or possibly quarterly.”

The recent drop in value of a2 shares while others lifted showed active managers were driving market movements, he said.

Craig Lazzara, managing director and global head of investment strategy for S&P Dow Jones Indices, said the data was clear that active managers would underperform over time.

Index funds were only about 5% to 10% of trading in the United States, and were not a significant influence on price fluctuation.

Kiwi Wealth recently released a white paper which looked at the merits of active and passive strategies.

It also warned against managers charging active fees but only delivering a small proportion of active management.

Comments from our readers

On 23 October 2019 at 8:02 am Pragmatic said:

This is where fact meets fiction. I have read and agree with the KiwiWealth report on active vs passive. It has been produced using facts, is devoid of emotion and provides sound and balanced reasoning behind the conclusions.

Conversely I’m assuming that Dean Anderson has been misquoted when he suggested that “…index funds would only invest proportionately to the value of the company and would not drive its value higher. Passive is not setting the price every day. The price is being set by the large volume of active trading.” I won’t dignify this comment with too much response aside from suggesting that dumb money chasing over-priced stocks because they form part of a meaningless index means that prices will be driven up even further.

For what it’s worth: Passive investing has a place within a portfolio and has largely become commoditised globally. NZ investors are very close to paying single digit bps to access this environment (which is commonplace elsewhere around the world), with those providers who justify charging more for the privilege finding themselves swimming against the technological-tide.

On 23 October 2019 at 10:18 am CJ2 said:

Are Kiwi Wealth really this misinformed? Plus their active share is appalling. MSFT AMZN and AAPL as largest holdings, that's worth high fees!

On 23 October 2019 at 2:22 pm Kimble said:

"passive management was problematic because it had an in-built tendency to buy more and more of the most expensive shares as they rose in value."

I hope this is a misquote.

Passive funds buy more shares of a company when that company enters the index or when the passive fund itself receives new investment. Unless one of those things happens, the passive fund does not buy any shares of anything.

A stock becoming "over-priced" does not cause a passive fund to buy more shares, unless that stock enters the index due to its new higher market-cap.
Ignoring fund flows, if a stock has grown from 0.01% of the index to 0.5% of the index, then a passive fund would not have bought a single extra share. They would have held the exact same number of shares throughout and seen the value of their holding increase 5000%.

A stock price falling does not cause a passive fund to sell ANY their holding, unless the stock drops out of the index due to their different market-cap.

The distortionary effects at the margin are valid criticisms of indexing, but the opponents never seem to restrict themselves to this. And it should be noted, for the large-cap indexers the errors they're making are going to be at the smaller end of their portfolio. It's a tiny impact on their overall portfolio.

Passive money doesn't chase anything. That's active management thinking.

On 23 October 2019 at 5:16 pm Pragmatic said:

Price-weighted indexes aren’t particularly common anymore. Still, one of the world’s most widely tracked indexes – the Dow Jones Industrial Average – uses price weighting - so in fact, the volume of investment actually drives the share price, which attracts more volume. Not a great outcome for passive investors when things go pear shaped.

Market-capitalization weighted indexes (or market cap- or cap-weighted indexes) weight their securities by market value as measured by capitalization: that is, current security price x outstanding shares. The vast majority of equity indexes today are cap-weighted, including the S&P 500 and the FTSE 100. In a cap-weighted index, changes in the market value of larger securities move the index’s overall trajectory more than those of smaller ones. Not a great outcome for passive investors when things go pear shaped.

On 23 October 2019 at 6:37 pm Michael Gray said:

There is a large and growing body of support for the position of the Kiwi Wealth’s researched conclusions. Index Funds do buy high and sell low, primarily because companies do move in and out of indices. For those interested, see the Research Affiliates research. (https://wp.me/p9pwgm-3n)
There is also a growing level of academic research challenging the "conventional wisdom" of active management i.e. it is in support of active management (https://wp.me/p9pwgm-45).
Index Funds also have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated. https://wp.me/p9pwgm-37
Also, there has been a disaggregation of investment returns (https://wp.me/p9pwgm-2f). This is most prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge.
The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.
Therefore, as the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio. The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).
As you know, this is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay active fees for an “active” return outcome that can be sourced more cheaply.

Passive managers reject criticism [+ WHITE PAPER]

Passive fund managers have hit back at suggestions that people with money in passive holdings may not understand the level of risk they are taking.

Wednesday, October 23rd 2019, 6:00AM 5 Comments

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