Is the continued flow away from active funds and into index funds the result of passive activities or the result of many active investment decisions and an active analysis of the evidence? In late 2016, a series about index investing ran in The Wall Street Journal titled "The Passivists” (Here are five compelling charts that make a strong case for index funds). I enjoyed the articles, but I wonder if the lead should have been, “Active Investing Leads Investors to Index Funds.”
Many articles are written about the various investment choices that investors have. Investing in index funds, however, is consistently called passive investing. Why? As the founder of a firm whose research often leads us to invest in index funds on behalf of our clients, I take some issue with the use of the word “passive." Passive, according to the dictionary, means “inert” and has synonyms such as “acquiescent,” “submissive,” “compliant” and “docile.”
Why Are Index Funds Called Passive?
First, those who know me well know that I have 100% of my family money in index funds and are probably cracking up at the thought of anyone describing me as compliant or docile. More importantly though, how is it that the “passive index" moniker came to be? Did the marketing team that coined emotional words such as “alpha” and “active” to describe stock-picking management, and make it easier to sell, also come up with the term “passive” to discourage index funds? (For related reading, see: The Lowdown on Index Funds?)
Do you want your portfolio managed by the star, active or alpha generating manager or the passive and submissive one? Charles Ellis, who was the chair of Yale’s investment committee for nine years alongside David Swensen, was asked at a recent family office conference: “What is the biggest risk you face when you invest in index funds?”
His answer? “Being called passive.”
At this same meeting, the chief investment officer of Exxon’s $30 billion+ pension plan also spoke. When the moderator asked him to explain his current equity portfolio, everyone leaned in to hear the latest hot tip, sector or manager.
Jaws dropped, and he could have dropped the microphone, after he basically said the following: “Simple, two index funds...one total market U.S. equity index fund that we run in-house for approximately 0.01% and one total international fund (developed and emerging markets) that we outsource to a leading index fund manager for 0.03%. That’s it.”
Why?
“We feel like we have a moral responsibility to find the best investments on behalf of our employees. It hasn’t been easy to resist the literally thousands of great presentations we have heard from managers and consultants, but we have yet to see evidence that justifies deviation from our simple strategy.”
Powerful stuff, and yes he really did say that he thought it was his moral responsibility to actively focus on just the evidence.
Over the past 30 years or so, I’ve also seen legions of excellent pitch books designed by talented professionals for most every type of investment product you can imagine. In addition, for many years I made a living as a successful advisor, marketer and, yes, salesperson of many stock-picking managers, alternative strategies and complex investment models. (For related reading, see: Is Stock Picking a Myth?)
Believe me when I say that the industry knows that it’s much easier to acquiesce to the excitement of the holy grail presentation than it is to endure the fear of missing out. Choosing index funds takes fortitude and carries with it the risk of being criticized for being passive.
Index Fund Management Activities
Are these activities passive?
- Actively resisting Wall Street sales presentations and short-term trading presentations
- Actively listening to clients and constructing customized goal-based portfolios anchored on long-term investment policy statements and guidelines
- Avoiding the temptation of the latest new product, sales incentive, prognostication or PhD.-driven, but opaque, investment model or hypothetical
- Analyzing the success and failure of different types of investments over various time periods and market cycles
- Carefully selecting a mix of investments based on the evidence, not emotion
- Managing, monitoring and rebalancing allocations and investment funds to stay anchored on long-term goals
Investors (individuals and institutions), who many call “passive,” do all of what is listed above and more. Where has this led them? To actively invest in index funds.
(For more from this author, see: Hedge Fund Returns and Taxes.)
cr. https://www.investopedia.com/advisor-network/articles/how-active-investing-leads-investors-index-funds/
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