In this piece, David Blitz provides an interesting perspective on using the passive framework as a blueprint for constructing active (ETF-like) products. The article is not an empirical (no charts!) nor a theoretical (no analytics) analysis, but is focused on just one question:
Is it efficient to implement an active strategy by using passive investing techniques, that is, to first turn the active strategy into an index and then replicate that index at low costs?
We clearly have our own thoughts on active techniques in a passive framework which you can read more about here. However, it’s always good to challenge your own thoughts and biases. The author of this paper does just that and argues against the adoption of the passive framework for active, including factor-based products. Five issues are identified and discussed with respect to the relative weaknesses associated with passive techniques and practices as contrasted with the requirements of successful active management.
Efficiency of trading
Risk of arbitrages or manipulation due to publicity surrounding trades
Dynamic basis of active strategies
What are the Academic Insights?
Performance accountability is weaker in the passive framework: There is an inherent limitation to fiduciary responsibility and performance accountability in the passive methodology. The index provider only provides paper portfolios and therefore is not incentivized to outperform the market after fees and costs. The index replicator is only incentivized to produce performance numbers that match the paper portfolio. The role of fiduciary ultimately defaults to investors who typically take a more charitable view of performance for index replicators than active managers themselves, especially with respect to underperformance and may be in an weak position to evaluate the product.
Efficiency of trading is also weaker: Factor index replicators are constrained by a lack of flexibility in trading that result in higher costs of trading when compared to active managers. Maintaining active factor exposures requires active trading, although most index providers rebalance quarterly or semiannually. That practice forces trading in large amounts into a concentrated period of time (usually a few days) on an annual basis. This eliminates the opportunity to engage in opportunistic events that require trading in smaller amounts over longer periods. For example, active managers enjoy a number of advantages including the ability to identify cheap block trading opportunities, the ability to use fund inflows to purchase highly ranked stocks and selling off poorly ranked stocks. The passive methodology essentially shuts out those types of liquidity events and alpha generating opportunities. As a result, passive investors are subject to relatively higher trading and market impact costs.
Passive funds have little to no control over capacity: Furthermore, the culture, mindset and most importantly the business model of passive management is decidedly inconsistent with capacity control. The ability to attract assets, to increase the size of a passive fund are instead considered indicators of success as the fund becomes increasingly able to benefit from economies of scale. In contrast, asset-gathering takes a back seat to generating excess returns as the first priority for active managers. They also have the ability to close funds to new investors if capacity limits are exceeded and generally expected to do so in order to protect performance.
Opportunities to manipulate prices or arbitrage: There are at least two issues associated with trading activity associated with the time lag that occurs due to the preannouncement of trades by index providers. Since the reconstitution of the index is announced prior to the actual trade date, there is a window of time available for other investors to act and profit by providing liquidity necessitated by the index provider. For example, hedge funds engage in index arbitrage by taking the opposite side of the index trade while the cost is borne by index investors. More significantly, the window also provides the index replicator an opportunity to influence prices of the stocks moving in and out of the index. A clear conflict of interest.
Passive strategies tend to be static: Index providers (and therefore replicators) resist changes to their methodology regardless of obvious improvements that could and should be made. To a certain degree, the resistance can be justified if the index is widely known and used by investors for benchmarking or risk control. Such unintended turnover in the replicated portfolio can be costly and undesirable from the index investor’s point of view. On the other hand, change is the currency of the active manager. As market beating performance is the objective, it is imperative that active managers have the flexibility to improve strategies.
Why does it matter?
The prototypical framework that has developed alongside of the passive approach to investing has been enormously successful. The theoretical propositions of a simple buy-and-hold strategy have delivered not only on performance but on the cost of investing for the retail market. Research demonstrates that the growth of passive investing has forced active managers across the globe to lower their fees and “up their game” in terms of returns. The lure of low costs is the obvious attraction to active managers to adopt a methodology similar to the passive case. However, the passive framework has a number of significant limitations that constrain its application to factor and other active types of strategies.
In sum, we identify five pitfalls when active investing is approached with passive investing techniques. First, the split in responsibilities between index provider and index replicator means that there is no more accountability for overall performance. Second, trading big on just a handful of days each year according to a preset schedule is inefficient and involves opportunity costs. Third, factor index strategies are active strategies focused on asset gathering and without the intention, or the means, to control capacity. Fourth, the preannouncement of index reconstitutions makes indices vulnerable to predatory trading by hedge funds, and to gaming by passive managers who can influence the prices against which they will be benchmarked. Fifth and finally, whereas active strategies can evolve based on new insights and research, index strategies tend to be set in stone, based on the knowledge at the time of their development.
Dr. Tommi Johnsen was a past Director of the Reiman School of Finance and a tenured faculty at the Daniels College of Business at the University of Denver. She has worked extensively as a consultant and investment advisor in the areas of quantitative methods and portfolio construction. She taught at the graduate and undergraduate level and published research in several areas: capital markets, portfolio management and performance analysis, financial applications of econometrics, and the analysis of equity securities. Her publications have appeared in numerous peer-reviewed journals.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.