Why Passive Investing Isn’t the Same As Index Investing

Investors today are confronted with a confusing choice between thousands of index mutual and exchange traded funds (ETFs). Unfortunately, too many of these investors may falsely assume that investing in index funds is the same thing as passive investing. They are different, and the distinction is important. In this section, we’ll explain why.

We will start with a short review of investment theory, and then use it to classify the many index mutual and exchange traded funds that are now offered in markets around the world.

Elsewhere on this site, we’ve already discussed issues related to the definition of asset classes. In our view, they should be broadly defined, which ensure that they are capturing significantly different underlying economic return generating processes.

Different statistical techniques can be used to perform this analysis, including correlation (true asset classes should have returns that have low correlations with each other) and principal components analysis (true asset classes should have different loadings on different return generating factors).

For example, consider the difference between domestic investment grade bonds and emerging market equity. The underlying economic processes that generate the returns on these two investments are quite different from each other.

In contrast, the processes generating returns on "large cap" emerging market equities and "small cap" emerging market equities are quite similar, as evidenced by the high correlation between their respective returns. Hence we regard these two categories not as distinct asset classes, but rather as an example of "tilts" or sub-segments within the emerging market equity asset class.

An asset class's return generating process can be broken down into two parts. The first is common to all the securities that make up the asset class. It is often called the "systematic" or "non-diversifiable" return on the asset class.

The second source of returns is either unique to a specific company, or common only to a subset of companies within the overall asset class (e.g., companies in the energy sector). Here is a simple example. Consider an asset class made up of only two securities, which have equal weightings on all possible measures (e.g., their market capitalization, their book value, their sales, etc.). The return on security A is 7%; the return on security B is 3%. The average return is 5%, which represents the systematic return on the asset class, which would be received by an investor who owned both A and B. The unique return on Security A is 2%, and on B it is (2%).

This simple example illustrates a number of critical points.

First, at the asset class level, the unique returns (also called "alpha" returns) cancel each other out, leaving only the systematic return. Traditionally, this has been referred to as the "market" or "beta" return. Investing with the objective of earning only this broad asset class return should, in our view, be called "asset class investing", "market investing", "beta investing" or "passive investing." As you can see, the distinguishing characteristic of the market return for an asset class is that it requires no ability or attempt to forecast A and B's future returns. It simply seeks the return that comes from owning all the securities in the asset class.

Second, return is compensation for bearing risk. At the asset class level, you receive only systematic market return, which compensates you for bearing systematic market risk. This systematic return is composed of two parts: the risk free rate (which compensates you for deferring consumption) and an asset class risk premium. Most important, earning this asset class risk premium does not depend on active investment skill.

A third insight from our simple example is that, when you take on additional unique risks that can be avoided through diversification, you may receive additional compensation in the form of positive alpha. In the short term, this can be due to either luck or skill. However, as you keep taking on unique risks over longer and longer periods, the probability increases that your average return will be either zero or negative (after your higher costs) - unless you have better than average forecasting skill, and can better (than the average active investor) distinguish between those unique risk exposures that will earn positive and negative alphas. This last point is crucial, but is too often overlooked.

Successful active investment is expensive, and doesn't just depend on having some forecasting skill. Rather, it requires that your forecasting skill be consistently superior to the average skill level possessed by the other active managers against whom you are competing. And that is a far higher bar than most people like to admit.

A fourth point is that superior forecasting skill must be based on either access to superior information and/or use of a superior model to make sense of publicly available information. It also must be based on the existence of a financial market that is not perfectly efficient.

In a perfectly efficient market, skilled forecasting is impossible because market prices already incorporate all the public and private information available about a security, and the pricing insights generated by many different models. As we have noted many times in our writing over the years, we believe that financial markets are not always efficient.

Rather, we see financial markets as a complex adaptive systems that, while strongly attracted to equilibrium and efficiency, seldom achieve it. Hence, we believe that skilled forecasting and successful active management that generate alpha are possible, though quite rare in practice, particularly as the forecasting time horizon lengthens (and especially after the additional costs of active management are taken into account).

The fifth point from our simple example is that asset class or passive investing, as we define it is not the same as "indexing" which is often incorrectly used as a synonym for it. This is a critical distinction, that we fear is lost on too many investors.
So in our next section, we'll take a closer look at the underlying issues.

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