The latest salvo in a long-running war of words between active and passive managers came recently from AllianceBernstein in a paper titled “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” The paper, which argues that passive investing misallocates capital, reminds me of a round of arguments a few years back between David Smith of the U.K.-based advisory firm, Hargreaves Lansdown, and Jack Bogle, the founder of Vanguard, in which each argued that active or passive managers are parasites.
Whether we are talking about Marxists or parasites, the criticisms from active managers tend to center on a free ride allegedly enjoyed by passive managers who do not contribute to price formation and hence to the capital allocation function of financial markets. The other side would argue that active managers neither add value in aggregate nor outperform the market consistently enough to justify their fees.
But talk of how passive investors benefit at the expense of active managers misses two important dimensions of how institutional investors use so-called passive instruments: to implement active asset allocation decisions and, through allocations to smart beta, as ways to correct or benefit from systematic mis-pricing. In reality, institutional investors use passive allocations in some very active ways.
Passive investing can reflect active views
Regarding asset allocation decisions, few institutional investors hold the global equity portfolio in its entirety; most still carry a heavy home bias. Second, most of the passive money is allocated to vehicles that track segments of the global opportunity set rather than the whole. Institutional investors would presumably do so only if they do not want to hold the entire universe of stocks at market cap weights. Otherwise, it would be more convenient to use an instrument tracking the whole universe such as the MSCI ACWI IMI index, which covers roughly 99% of global equities. Therefore, it would be safe to assume that a lot of passive allocations in fact reflect active views implemented via indexation. For example, institutional investors may invest in an ETF that tracks the MSCI Emerging Markets Index to reflect market-cap weights or an active view of that segment of the market.
More importantly, the rise of factor investing (or smart beta) shows that investors are ready to combine systematic repricing strategies with low-cost index-based strategies. When a value factor index or quality factor index gets reviewed twice a year, stocks with high valuations or low quality will fall out of the index and subsequently be sold by index funds. In effect, a securities re-pricing mechanism is embedded in the index rebalancing function. Due to the systematic nature of those indexes, the approach can be applied to a large universe of stocks and could be deployed on large pools of assets, provided that the index methodology includes well-designed rules to manage capacity and investability.
How market cap weights get adjusted by large institutional investors in their policy portfolios
In reality, institutional investors have different objectives, constraints, investment beliefs or risk appetites. It would be surprising if they all want, or need, to hold the same portfolios. These preferences bear on the capital allocation process.
The exhibit above summarizes the steps that an institutional investor might go through to adjust the market weight to get to an actual policy or reference portfolio. At each step, the investor decides, actively, how to construct the portfolio, including whether it should be implemented through passive or active managers.
From that perspective, investing is by nature active but portfolio construction decisions may lead to “passive” implementations.