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Dimitris Melas

Dimitris Melas
Managing Director, MSCI Research

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Separating facts from fiction in passive investing

For institutional investors, float-adjusted market capitalization-weighted indexes remain the tools of choice to implement their passive allocations. Such indexes are used widely as policy and performance benchmarks and as the basis for ETFs and other vehicles. Is this use justified or even appropriate? Do benchmark indexes suffer from shortcomings that undermine their suitability in implementing investment strategies?

Passive investing through market-cap weighted indexes represents the only macro-consistent buy-and-hold investment strategy. Indexes weighted by market capitalization reflect both the full opportunity set for investors and their aggregate holdings.

Portfolios tracking these indexes typically benefit from low turnover, low transaction costs, high trading liquidity and the ability to absorb vast amounts of capital. For these reasons, indexes have proved over time to be valuable tools for market research, asset allocation, performance benchmarking and passive replication that can help capture the return associated with the broad equity market.

Passive investors - far from freeloading on work by active managers to value companies - demonstrate a belief both that markets work and that, in the absence of insights, holding the market enables them to bear systematic equity risk and capture the equity risk premium.

An objective representation of the market

Market cap indexes reflect the aggregate views of investors, which makes such benchmarks an objective representation of the market. These indexes do not arbitrarily weight the companies, industries or countries that constitute them. The fact that Apple, and Facebook occupied 2.77%, 1.5% and 1.37%, respectively, of the MSCI USA Index as of June 30 reflects the collective wisdom and actions of investors rather than a decision by the index provider. The same principle holds for the weight of the U.S. in a developed markets index, or the weight of China, Korea and Taiwan in an emerging markets index. Blaming benchmarks for the weight they attribute to an asset is like blaming the thermometer for the weather.

Some commentators have criticized benchmark indexes for using market prices to determine asset weights, or accuse indexes of being inefficient or even “dumb” because they attribute high weights to expensive companies. But the companies are expensive according to whom? Market prices, reflected in indexes, are simply the views of investors as a whole.

Active strategies can be passively replicated

Critics of passive investing go as far as suggesting that an automatic rebalancing strategy that uses fixed weights is likely to outperform cap-weighted indexes. But the evidence suggests otherwise. Witness how difficult active managers find it to beat cap-weighted indexes consistently. If benchmarks are so inefficient, why do active managers, who have all the incentive in the world, struggle so mightily to beat them? 

Passive investing is hardly a panacea for investors. But much of the criticism against it is unfounded. Passive investing, factor investing and active management represent alternative ways to manage a portfolio. Factor indexes, which mirror active strategies, show that such strategies can be passively replicated. But investors have a choice and they are voting with their money. And their money is moving more and more toward passive mandates and factor-based strategies.


Further reading:

Fighting Marxism with smart beta

Some Like It Hot: Very Active Mandates in a Core-Satellite Structure

Pagination Portlet