“Passive” equity investing, which puts money into funds that mimic indexes, has become popular over the past few years. And, why not? The S&P 500 has risen 250 percent since its nadir in March 2009, equating to an annualized growth rate of 15 percent. The narrative of those with a vested interest in passive funds goes something like this: “Over the past few years, up to 90 percent of active equity managers (i.e., stock-pickers) have under performed the S&P 500 on a net of fee basis.” From this statement, they push the conclusion that passive indexing always and everywhere is superior to active management.
Active vs. Passive – Equities: The Historical Record
Such a conclusion, however, is not justifiable. Like many other data sets, this one also has a cycle. In the 1970s, only 10 to 20 percent of active fund managers beat the S&P 500. But, by the mid-1980s, that number was over 90 percent. A similar cycle occurred in the late 1980s and early 1990s. And it is interesting to note that more than half of actively managed equity funds outperformed the S&P 500 throughout most of this century’s first decade. The historical record shows that active managers outperform the S&P 500 index over five or ten-year periods about 50 percent of the time.
Active vs. Passive – Fixed Income: The Historical Record
Another misconception is that the “passive” versus “active” discussion is the same for fixed-income fund managers as it is for equity fund managers. The truth of the matter is that, in the fixed-income space, active managers regularly outperform their benchmarks on a net of fee basis. Data from Morningstar show that the median active fixed income manager beat their passive benchmarks over the past one, three, five, seven and ten-year periods. eVestment, a Nasdaq owned data provider with up to 40 years of data for some active funds, concludes that more than 95 percent of active fixed-income managers outperform, with the median manager delivering gross returns 114 basis points (1.14 percentage points) above their passive benchmarks.
There are several structural advantages in fixed-income investing that give active managers an edge, including the way the benchmarks are structured, their turnover rate, the need for liquidity, their concentration on about one-third of the fixed-income universe, and their trading frequency.
Equity indexes are market-cap weighted which means that the most successful companies whose stock prices have risen most have more weight in the index—i.e., they are weighted according to the total market value of their outstanding shares. For example, in the S&P 500, Apple’s weight is 3.666, Microsoft’s is 3.192 and Exxon’s is 1.507, while Western Union’s is 0.040 and Mattel’s is 0.020. Thus, a $1 move in Apple’s share price exerts an influence on the index 183 times more powerful than a $1 move in Mattel’s share price does even though Apple’s price ($162+) is only 11.5 times larger than Mattel’s ($14+). The fixed-income benchmarks, which passive funds mimic, use a similar weighting methodology. In this case, the most heavily weighted entities are those that have issued the most debt.
Largest Debt Issuers
The benchmark is meant to show the typical yield for the category being measured. This means that the benchmark must include countries and companies that issue the most debt because these have the most weight in the scheme of the world. Because there is always a market for the largest debt issuers (the large dealers always have such inventory), those benchmarks only include such issues because prices and yields must be readily available and must smoothly follow market trends.
Since sovereign governments are generally the largest debt issuers, the benchmarks and passive funds include a large percentage of these. The U.S Treasury is the largest debt issuer in the world, and because nearly all its issues are highly liquid and trade in volume every business day, all the benchmarks and passive fixed income funds hold a significant portion of their assets in such paper. The corporate debt that they hold also tends to be the debt of the largest issuers like the telecoms and megabanks.
For example, AGG (iShares Core U.S. Aggregate Bond EFT) holds 47 percent government paper, 27 percent mortgages and 28 percent corporate paper. Another large passive fixed-income fund, VBILX (Vanguard Intermediate-Term Bond Index) holds 56 percent government paper and 43 percent corporate.
Quality and Yield Issues
Passive products increase an investor’s exposure to lower quality, lower yielding credits. Regarding quality, some heavily indebted governments can, and occasionally do, default on their debt (e.g., Venezuela). Furthermore, the largest corporate issuers don’t always have pristine financials.
When it comes to yield, most government debt (e.g., the U.S., E.U. and Japan) generally has the lowest yield for items of similar duration. In addition, the international passive indexes include the world’s negative yielding debt (Japan and the E.U.). Those negative yielders are there for political and/or central bank policy reasons. But because of the size of the debt and the intent of the benchmark, they must be included. In the end, passive investors pay a premium for liquidity that the benchmark needs, liquidity that does not benefit them, and they also receive substandard returns. So it isn’t any wonder that active managers easily beat the passive fixed income fund returns.
Most passive fixed-income investors are unaware of the frequent turnover in the benchmarks. For the three years ending 10/31/17, the turnover rate for the U.S. Aggregate Index was 40%, compared to the S&P 500’s turnover rate of less than 5 percent over the same period. Even worse, in the 12-month period ending 2/28/17, the passive ETF that follows that index, AGG, had a 242 percent turnover rate. Such turnover increases trading costs, and could radically change an investor’s exposure in a passive fund. For example, since the recession, the composition of AGG has changed such that today, its duration is 62 percent longer and its exposure to U.S. lower yielding Treasury Notes is 15 percent higher. Lower yielding! Longer duration! What was I thinking when I purchased that!
The Benchmark’s Limited Universe
The concentration of the benchmarks—and the funds that mimic them—in the largest debtors and the most highly liquid debt also means that a large portion of the investible universe is excluded. For example, the U.S. Aggregate Index excludes all non-rated issues, all inflation indexed issues and foreign currency issues. In addition, because most passive funds are algorithmically driven by computers, their portfolios are rebalanced monthly or quarterly.
Active managers, on the other hand, trade opportunistically. Active managers can own the debt of small issuers, normally at higher yields and with higher quality balance sheets, income statements and cash flows than those of the largest debtors. Active managers have more choice and they don’t have to concentrate on lower yielding, and sometimes lower quality, sovereign issuers.
The Judgment Factor
Passive strategies have no human management or macro- or micro-analysis. In an actively managed fixed-income ETF, the managers can detect an oncoming rise (or fall) in the general level of interest rates, or changes in the shape of the yield curve, and position the fund to take advantage. In addition, the managers can change asset allocations to take advantage of business conditions in different sectors, while passively managed funds are stuck with the allocations of their benchmarks.
• In the equity world, the cycle determines if active or passive strategies outperform. Of late, passive equity strategies have outperformed, but the tide appears to be turning;
• Unlike the equity world, in the world of fixed income, active managers significantly outperform passive strategies with the median outperformance of 1.14 percentage points gross of fees;
• The benchmarks, which passive funds mimic, select the largest debt issuers and the most liquid of those issues. Investors in such passive funds generally get lower quality and lower yield than they would with active managers who are more skilled and nimble in their asset selection, in trade execution, and in the implementation of strategies that fit into the current macro- and micro-economic picture.