A major point of distinction for financial advisors and investors when examining mutual funds or exchange-traded funds (ETFs) is whether the portfolio management on that product is an “active” or “passive” strategy. Yet, it turns out that a “passive” investment may be not exactly what everyone believes it to be.
Recent research from Adriana Robertson, assistant professor at the University of Toronto’s faculty of law and in finance at the Rotman School of Management, suggests that most of what people consider to be passive investment vehicles – ETFs or mutual funds that purport to track a particular market index – are not really passive. Rather, they’re much more actively managed than presumed.
The key misconception about both index funds and the indexes they track is that they are based on hard and fast formulas that follow immutable rules, with little or no interaction by humans, says Dr. Robertson, whose paper on the subject, Passive in Name Only: Delegated Management and ‘Index’ Investing, focused on index funds in the United States.
In reality, indexes themselves are created, then tweaked or altered, by human beings, she says. They have become tools that portfolio managers follow when assembling ETFs and mutual funds – with investors not always aware that someone, or a team, is actually managing the index itself.
“Indexes are made by people too. We have it in our minds that an index is somehow separate from discretionary decision-making, but it’s not,” she says. “Rather than being passive in any meaningful sense, index investing [buying funds that track an index] simply represents a form of delegated management. Tracking an index [through a fund] almost always implies choosing a managed portfolio.”
In fact, about 15 per cent of index funds in the U.S. are based on indexes that are created or run by the same management teams that manage the funds, Dr. Robertson says.
Even when it comes to use of the term “index investing,” there’s a lot of confusion, she notes. Many people aren’t clear on the difference between an index itself and the investment fund on which the index is based as ETFs or mutual funds that track an index are often colloquially also called “indexes.”
“Sometimes, people also use the term ‘index’ to indicate an index fund, which is a mutual fund or ETF that tracks an index,” Dr. Robertson says. “People also sometimes use ‘index’ when they’re referring to a benchmark. These are all quite different concepts.”
Although a benchmark is used to compare the performance of a particular fund, the fund can be designed to track a particular specialized underlying index and/or outperform other more general indexes.
At issue for advisors and their clients is knowing what they’re investing in. It’s a matter of determining what elements go into establishing a passive ETF or mutual fund that’s based on an underlying index.
“For my paper, I read the methodology of more than 600 [U.S. equity indexes on which index ETFs and funds are based] and I found that there is a huge amount of variety across them,” Dr. Robertson says.
Namely, they all have methodologies, but these can vary from thick books of explanations to one-page summaries to a message stating that the index’s methodology is proprietary and cannot be shared.
“Just saying ‘follow the index’ is not enough. The one you pick can be pretty important. … While in theory it would be possible to construct an index … that is purely mechanical and fully transparent … after reviewing the methodology documents of over 600 [indexes], I did not find a single one that operated in that way,” Dr. Robertson says.
It’s worthwhile for advisors and investors to understand indexes and how they behave, if only because index funds “are responsible for directing trillions of dollars’ worth of investment,” Dr. Robertson says in her research paper.
Global assets under management in ETFs, which dominate the passive index sector, topped US$5.4-trillion as of April 30, according to ETFGI. In Canada, almost $179-billion was invested in ETFs as of that same date, the Canadian ETF Association reports.
The majority of ETFs purport to be passively managed and thereby track an index, she says, adding that some mutual funds are also labelled as passive, although many are actively managed and don’t follow an index.
The Bank for International Settlements published a report last year, The Implications of Passive Investing for Securities Markets, which found that “passive funds managed about US$8-trillion or 20 per cent of aggregate investment fund assets [under management] as of June 2017, up from [eight] per cent a decade earlier. Passive (or index) mutual funds, the traditional passive portfolio product, grew sharply over this period. ... ETFs’ share of passive fund assets exceeded 40 per cent in June 2017, compared with around 30 per cent in 2007.”
“In recent years, the importance of index funds has only increased,” Dr. Robertson says.