Anything but passive

A market cap weighted index fund, is perhaps the most common form of passive investing. It is low-cost and seeks to replicate and hold securities included in a market index.

Traditional market capitalisation weighted indices such as the S&P 500 or S&P/ASX 200 are constructed using an approach that assigns greater weight to larger companies and less to smaller companies. For example BHP which is the largest company on the ASX makes up around 10% of the S&P/ASX 200. These funds regularly adjust their constituents’ weights to reflect changes in market capitalisation.

The active ‘bet’ investors in these passive funds are taking is that those companies with the greatest growth potential are the largest ones, because they get more of an investment. This is not always the case, hence the rise of different passive index approaches, such as equal weighting and factor-based investing. 

Irrespective of the index approach, the passive fund manager is anything but.

As noted by Rick Ferri in Forbes, index construction methodology has rules for inclusion and exclusion and index constituents change often. There are buyouts, mergers, and other types of corporate actions; interest and dividends are paid and need to be dealt with; and then new issues come to market and decisions are made when to include these securities. All of these factors, plus many more, confront the ‘passive’ index fund manager.

Passive investing as such doesn’t exist. Only lesser degrees of active investing.

For years the question of ‘active’ versus ‘passive’ investment funds has been debated by participants in financial services. These classifications are often misidentified and misunderstood, as ultimately, they could both be defined as active.

This is because many so called ‘passive’ investments, while not engaging in ‘active’ stock picking can have similar performance and risk characteristics of active investments. This is due to the active nature of the underlying index that the passive investment seeks to track.

Rather than passive fund managers just sitting there not doing anything, much of the innovation within financial services comes from this segment of the industry. This innovation gives investors new choices and opportunities.  Investors now have cost effective access to ‘passive’ tools that can outperform the markets, something they have traditionally paid more expensive active managers to do. 

In fact, actively choosing the passive approach, has, for many investors paid off, as active fund managers have a questionable track record.

According to the SPIVA scorecard produced by the S&P Dow Jones Indices, over the last 15 years almost 84 per cent of actively managed Australian equity general funds underperformed the S&P/ASX 200.

Active fund managers have long said that an active approach is the best way to navigate volatile markets, such as the one we are currently in. However, recent data shows that while some active funds have outperformed the ASX200, the majority have failed to do so.

The latest SPIVA scorecard revealed only 31.8 per cent of Australian equity mid and small cap funds beat their benchmark indices in the six months ending 30 June, 2022.

It turns out it is as hard for investors to select the active fund that will do well as it is as hard for active managers to outperform. It is no surprise then that investors are choosing passive funds.

The Oracle of Omaha, Warren Buffet agrees. In his 2017 letter to shareholders he said, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

In fact, Buffett said he was willing to bet anyone $500,000 that over ten years, an S&P index fund would outperform a collection of hedge funds.

Buffet’s bet was this : Over a 10-year period commencing January 1, 2008, and ending December 31, 2017, the S&P 500 would outperform a portfolio of five hedge funds of funds, when performance was measured on a basis net of fees, costs and expenses.

Buffett, who chose an Index Fund that tracks the S&P 500, won by a landslide. The Hedge Funds had an average return of only 36.3 per cent net of fees over that ten-year period, while the S&P index fund had a return of 125.8 per cent.

So maybe passive investing isn’t such a bad option.

But why does active management have such poor performance particularly in equities?

According to Pisani:

1. The fees are too high, so any outperformance is eroded by high costs.
2. Fund managers often do too much trading which can compound investment mistakes and lead to a higher tax bill.
3. Most trading today is done by professionals who are trading against each other. These traders, for the most part, have access to the same technology and the same information as their competition. The result? Most have little if any informational advantage over their competition. 

And investors it seems, increasingly agree. According to Morningstar as reported in The Australian, passive investment funds now account for more than 30 per cent of the Australian sharemarket and if anything the shift from active managers is accelerating.

One of the side effects of increased flows into passive funds is increased ‘passive’ ownership in companies and thus voting power. The passive manager should not be confused with passive voting, when it comes to proxy voting.

Proxy votes are collective ballots cast on behalf of investors at company annual general meetings. Examples include proposed changes to share ownership, the structure of the board of directors, merger or acquisition approvals, and executive salary and benefits.

From VanEck’s perspective, contrary to popular belief, passive ETFs do make active decisions when it comes to proxy voting elections. This is an important part of our governance.

At VanEck, we monitor and review all proxy votes. We also use Glass Lewis for assistance and they have developed a specific set of ESG proxy voting guidelines that closely align with our views and in our opinion satisfy the high standards expected of a fiduciary.

As an example, we recently voted against the remuneration report for listed property giant Dexus because we felt the amount of one-off bonuses was too high. We have been ‘active’ with AGL’s board and its proposed demerger.

You can read more about our approach to proxy voting here and view our proxy voting reports here.

The shift in investors’ preference from active managers to passive funds has hurt the profits of active fund companies, but it helps investors by offering more transparency over holdings, savings on fees, diversifying portfolios and enabling access to a broader range of asset classes.

Remember when you buy a passive fund there is still a fee, but the fees are generally substantially lower than what active managers charge. Not all ETFs are created equally, make sure you do your research, talk to a financial advisor and work out which ETF best suits your investment goals and risk profile.