How Active is Your Passive?

Finding the Active in Low-Cost Passive Investing
There are any number of ways to construct an index. Some lead to more trading than others, increasing expenses.
Bloomberg, July 18, 2017

 

 

 

I have long defended the idea that a substantial portion of your investable assets should be in a portfolio of low-cost, global, passive indexes. My primary beef with much of the active universe (especially hedge funds and private equity, and the pensions and endowments that love them) is the one-two punch of high expenses and underperformance. And if you are going to pick stocks as an active investor, then be active — don’t be a closet indexer. Otherwise, you might as well buy a low-cost index fund and be done with it.

There have been some legitimate criticisms raised about the huge and sudden rise of indexing, many of them foolish. No, passive investing is not “worse than Marxism.” 1 No, Vanguard Group Inc. isn’t a “nonprofit socialist enterprise.” Passive isn’t a bubble; it isn’t destroying price discovery; it isn’t hurting the economyruining the market or investing; it’s not even (yet) putting security lawyers out of work.

However, passive, low-cost, index-based investing isn’t truly, objectively passive. It involves some decision-making, mostly choices that were made in the past by others. Modern passive investors merely default to these earlier decisions. That doesn’t make the historical legacy any less active, but it helps to understand the reasons behind these past choices: they were made for purposes of convenience, cost and efficiency.

First, consider the passive equity indexes. These were created using market capitalization weighting long ago; they could just have easily been equal weighted2   Cap weighting was the choice made by Vanguard founder Jack Bogle 41 years ago when he introduced the initial Vanguard 500 Index Fund, which was designed to track the performance of the Standard & Poor’s 500 Index. His thinking: it was the cheapest way to construct and manage an index.

He had other choices. He could have selected equal weighting. However, price changes of each individual security would have quickly moved the index away from equal weight. Maintaining equal weighting of the 500 stocks in the S&P 500 would have required regular rebalancing — perhaps as often as quarterly or even monthly — driving up trading costs. It is easy to see why Bogle went with cap weighting.

That also leads to the S&P 500 itself: Why rely on the assessment of S&P to come up with 500 names? Why not simply take the 500 biggest publicly traded companies and save money on licensing the index from S&P? The S&P index methodology explains how it selects companies, mostly relying on market value. But other factors enter into the calculation. First, S&P distributes the stocks across 11 industrial sectors. But it also looks at issues of liquidity and public float, as well as home domicile . . .

 

 

Continues at: Finding the Active in Low-Cost Passive Investing

 


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