Straitjacket investing: Passive has its limitations
By Douglas Hodge | February 5, 2013 10:00 am
In 2012, investors directed a record amount of their mutual fund dollars to indexed strategies. This trend is part of an explosion of investor demand for passive strategies that has been under way since the global financial crisis began. In fact, over the past four years, equity investors allocated an astonishing net $426 billion to indexed mutual funds and exchange-traded funds in the U.S., according to Strategic Insight data. Over the same period, they withdrew $310 billion from actively managed equity mutual funds and ETFs.
There are a number of explanations for this phenomenon. The most obvious cause is rising investor disenchantment with actively managed equity funds — and perhaps with good reason. While some fund managers have been able to deliver above-market returns, since 2009, on an after-fee basis, the average actively managed equity mutual fund actually has lagged its benchmark by roughly 50 basis points, according to Morningstar data. In fixed income, the trend toward indexing has been less pronounced. Over the same four years, U.S.-based active bond funds and ETFs took in $918 billion vs. $251 billion in indexed bond funds and ETFs, Strategic Insight data show. Many active managers have delivered returns above the comparative indexes during this period.
Still, the move to passive is substantial. Is this a good thing? By way of answer I would offer an analogy to the brainchild of a French upholsterer named Guilleret, who in 1790 invented the camisole de force — an innovative garment otherwise known as the straitjacket. It was designed to restrict mentally ill or violent patients from hurting themselves. Over the next two centuries straitjackets evolved to become instruments of punishment and torture. One might ask if a similar evolution is occurring in the world of investments, where passive strategies, originally designed to protect investors from “hurting” themselves from active management, might well be punishing investors instead.
While investors might believe they are prudently resorting to index-style investing to safeguard their portfolios from the hazards and disappointments of active management, a simple analysis shows that “herd indexing” may be suboptimal for both the investor and the broad economy.
Consider that most of the indexes that serve as the benchmarks for these passive investments are simply not optimal. Indeed, there is strong evidence that traditional capitalization-weighted indexes are wholly inefficient.
For example, looking at equity indexes, if one believes that every stock has an intrinsic fair value based upon the marginal return on invested capital, then an optimal index would risk-weight the stocks in its composite based upon these expected returns and their associated volatilities. But investors who passively rely on a capitalization-weighted index allocate capital on the basis of the value of the stock outstanding, regardless of the expected marginal return on that capital. This would certainly qualify as one form of an investing straitjacket.
The index weightings will also migrate through time as companies whose stocks have appreciated the most will garner a higher allocation within the index and, conversely, companies whose equity values have depreciated will lose index share. It stands to reason some of the appreciated stocks will be above their fair intrinsic values and some of the fallen stocks will be trading below their intrinsic values. So by definition an investment strategy based on a capitalization-weighted index will tend to overallocate to overvalued stocks and underallocate to undervalued stocks. Because passive investing is essentially blind investing, these distortions will grow as more money flows into cap-weighted, passive approaches.
Similarly, investment strategies based on capitalization-weighted fixed income indexes will overweight the most indebted — and arguably riskier — issuers and underweight the less leveraged, higher-quality companies. This line of argument simply points out the known suboptimal qualities of cap-weighted indexes.
More perverse is the distortion to the capital allocation system that is at the core of market-based economies and the root of our open, freely trading equity markets. In theory, the stock market should serve as a self-correcting clearing mechanism, where capital is awarded to the corporate winners and taken from the losers. It is designed to bring together investors, speculators and savers, who with their varying risk preferences and return objectives serve as the marginal price-setters of risk capital, company by company.
Arguably, when one investor chooses to index her portfolio she can achieve exposure to efficient markets at a lower cost. However, at the extreme in which all investors choose to index their portfolios, the price-setting mechanism that discriminates among high-, modest- and poor-performing companies is no longer acting efficiently. The best companies are capital-starved, while poorer companies are unduly enriched in what becomes a “socialist tax” on the economy.
Indexers or other price-insensitive buyers can also artificially lower price volatility, another form of market distortion. This phenomenon is at work in the bond markets today, where central banks on three continents are buying up large portions of their respective bond markets in an effort to drive yields and volatility lower — another straitjacket. Lower volatility tends to motivate momentum buyers to follow along. History tells us that these strategies work until they don't. Once the price-insensitive buyer steps away, volatility can rapidly spike, leaving the price-sensitive investors “long and wrong.”
Such situations also highlight the dangers of passive strategies from a risk management perspective: They typically rely on tracking error — how much the portfolio return deviates from the index return – as the sole risk management tool. To the extent an index has a large portion of its underlying volatility driven by markets that are distorted or influenced by price-insensitive buyers, investing in a passively managed index fund with low tracking error matters little when the absolute volatility level of the index can lead to large losses.
How now, active?
If index investors and other suboptimal buyers are distorting the markets, it should arguably present an opportunity for active managers to exploit. If so, then why have they not done better during the post global financial crisis period? The answer has to do with timing and timeframes.
Put another way, there will come a point when the misvaluations will become so compelling the pendulum will swing back toward active management. This should serve as a clarion call to talented, proven active managers. In 2009, Martijn Cremers and Antti Petajisto, finance professors at Notre Dame and Yale, respectively, published extensive research indicating that active managers whose equity funds had a larger active share (i.e., the absolute sum of portfolio holdings that differed from the benchmark index holdings) delivered the highest and most persistent returns. Similarly, their research showed that active funds with the lowest active share (“closet benchmarkers”) tended to underperform their benchmarks.
Whether it is stocks, bonds or other assets, an active manager with a rigorous top-down and bottom-up investment process and an outlook that vets the potential for a variety of both short- and long-term developments should be able to outperform a benchmark over time, adding value for investors.
Still, the recent statistics do not lie. As a group, many equity managers have underperformed and overcharged for active equity management. It appears too many closet indexers have disguised themselves as active managers, and with little result to show for it.
Nonetheless, I suspect Professors Cremers and Petajisto would find it difficult to explain the magnitude of the exodus from actively managed funds in favor of indexed strategies. Since the global financial crisis, investors have become less confident and less patient with active managers. During this recent period when flows into indexed strategies have been so strong, active managers, who are ostensibly paid to deviate from the indexes, will naturally underperform. For example, in 2012 there was a high correlation among funds that underweighted Apple Inc., the second-largest stock by capitalization in the Standard & Poor's 500, and their underperformance — that is, until the fourth quarter, when Apple dropped 21%. Following the crowd works until it doesn't.
This in turn raises the issue of timeframe. How long should investors tolerate underperformance of their active managers? Remember that behavioral finance has proved that investor impatience can contribute to poor portfolio performance.
Owning a composition of stocks — whether it is the Nifty Fifty, the dot-coms or “the index” — without regard to the expected future marginal returns on invested capital is choosing to wear an investment straitjacket. While passive strategies can protect us from our worst predilections of fear and greed, they can also serve to artificially restrict the free flow of capital into an optimal set of investments and potential returns.
Finally, it is incumbent on the active asset management community to be transparent about the risks of their respective approaches, and to guard against style-invisible drift, particularly as some managers appear prone to masquerade as active managers while they actually have disturbingly low active share.
The capitalistic economies of the developed nations are being tested as a result of persistently high debt levels, low job growth and increasing political dysfunction. Well-functioning capital markets that allocate risk capital efficiently and optimally are our best way out of this troubling triple threat. The community of active investment managers can and should do better. Investors deserve a better option than straitjacket passive strategies, especially in this policy-driven, debt-burdened, modest-growth environment.
Douglas M. Hodge is chief operating officer of Pacific Investment Management Co., Newport Beach, Calif., and a managing director in the Newport Beach office. He also serves on PIMCO's executive committee and on the global executive committee for Allianz Asset Management.