The first part of this look at fuzzy terminology in the investment industry covered the ambiguities around the word “advisor.” Now let’s turn to another confusing description, this time in regard to an investment strategy.
What is “passive investing”?
Investopedia, the most popular online source of definitions for investment terms, summarizes it in this way:
Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing is one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon.
An entry in Campbell Harvey’s glossary reads, “Buying a well diversified portfolio to represent a broad-based market index without attempting to search out mispriced securities.” But there are other definitions, including one that links directly to “indexing,” which is defined as:
A passive instrument strategy calling for construction of a portfolio of stocks designed to track the total return performance of an index of stocks.
The most recent fact book from the Investment Company Institute echoes that, describing passively managed portfolios as those “in which the adviser seeks to track the performance of a selected benchmark or index.”
In these and other definitions, “passive” and “indexed” are used interchangeably, an approach that is the norm for many media outlets and investment organizations.
A little history
Early on in “the index revolution,” the idea of “tracking an index” meant “tracking the market,” with the market being the S&P 500, viewed as the best gauge of the performance of U.S. stocks, even though it included a relatively small percentage of them.
In 1991, William Sharpe argued, in “The Arithmetic of Active Management,” that the indexes used should be broader than the S&P, while putting a stake in the ground regarding those definitions:
A passive investor always holds every security from the market, with each represented in the same manner as in the market.
An active investor is one who is not passive.
Subsequent developments would take things in the opposite direction, toward narrower and narrower indexes — and a much different application of the terminology.
The Investopedia entry referenced above mentions minimizing transactions and long-term holding periods as a tenet of passive investing. The original concept behind the name was all about owning the market and not trying to buy or sell in an attempt to outperform. Also implicit in the approach was the market-capitalization weighting framework referenced by Sharpe.
Over time, that total package (which in turn resulted in much lower costs for an investor) became the passive side of the active-versus-passive debate that has been raging ever since.
Today, the “passive” mantra has been co-opted and applied to strategies very far afield from the original intent. While just a few indexes were in existence fifty years ago, now there are thousands of them, with more created every day. Very few could be described as broad-based, and as index providers have sliced and diced the investable markets into ever-finer pieces, the trading of those pieces has increased dramatically.
The ETF pivot point
For the first twenty years or so of their existence, index funds (retail and institutional) mostly followed the original principles. The pivot point came in 1993, with the debut of what is now called the SPDR S&P 500 ETF Trust. It replicated the same popular index, but it could be traded intraday on an exchange. (There went the no-transaction part of the idea.)
As interest in the ETF structure built over time, sector ETFs came on the scene, as well as ETFs based upon other indexes that had become widely used for the analysis of active manager performance. Eventually, indexes were created just to be able to create ETFs. Index-based investment vehicles had morphed from a way to play long-term market potential to an engine for generating revenues for brokers and asset management firms.
Despite all of the changes, we’re still using the old words to describe vehicles that look nothing like the old vehicles. For example, if you see statistics from Morningstar about active and passive strategies, it considers “passive” to be anything that is based on an underlying index. Thus, the latest fund fee study from the firm has an equal-weighted passive average fee well above where you might expect if you were using the lens of the traditional passive approach:
An excellent paper, “Competition for Attention in the ETF Space,” lays out today’s environment:
The interplay between investors’ demand and providers’ incentives has shaped the evolution of exchange-traded funds (ETFs). While early ETFs offered diversification at low cost, later ETFs track niche portfolios and charge high fees. Strikingly, over their first five years, specialized ETFs lose about 30% in risk-adjusted terms. This underperformance cannot be explained by high fees or hedging demand. Rather, it is driven by the overvaluation of the underlying stocks. Overall, providers appear to cater to investors’ extrapolative beliefs by issuing specialized ETFs that track attention-grabbing themes.
An earlier version of the paper said that “financial innovation in the ETF space follows two paths: broad-based products that cater to cost-conscious investors and expensive specialized ETFs that compete for the attention of unsophisticated investors.”
That’s where we are. Many people and institutions implement the original form of passive investment — and many call what they do by the same name, even though it is unlike it in every respect but one. The only thing the two approaches have in common is the tracking of an “index,” which isn’t even a meaningful distinction any more, now that indexes create little worlds of their own rather than capturing the overall characteristics of a market.
So what?
A central tenet of The Investment Ecosystem is that we operate in a complex adaptive system that is always evolving. But categories often don’t keep up with the developments, and a term that used to mean one thing can now mean another. That’s not a huge problem if everyone is on the same page, but we’re not.
Obviously, it’s unrealistic to expect that the industry will shift to some more nuanced approach any time soon. But that doesn’t prevent your organization from doing so.
The purpose is not to come up with some sort of degrees-of-purity scale based upon the original concept of passive investing (unless that fits with your investment beliefs), but to have a framework for understanding.
The process of evaluation may lead you to make changes on the investment front, but the main goal is to examine how you communicate what you do — and how you use the words “passive” and “active.”
You might find them in your newsletters or on your website. They may even be ingrained into your client portfolio reports. What do they mean in those contexts — to you and to your clients?
Look around. Some firms promote “passive” approaches — taking advantage of the salience of that term — when the strategies they offer involve layers of active choices. Others try to hew to an ideal like Sharpe’s — and a few off them tie themselves in knots over some of the sticky implementation questions that arise when trying to reach that goal.
The education of clients is a core responsibility. Markets are uncertain enough on their own; don’t make them more so by using inexact descriptions just because everyone else does. Simple explanations that enlighten should be part of the mission.
Published: February 12, 2022
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