Passive Management Issues

Index Funds Issues

Passive management (also called indexing) is a portfolio management strategy based on purchasing exactly the same stocks and bonds, in the same proportions, as an index.  The idea is that the average investor will benefit more from reducing investment costs than from trying to beat the average. Index fund performance can differ from the performance of the index that are trying to replicate for a number of operational reasons, in addition to management fees.  A Morningstar survey found an average tracking error of 38 basis points across all index funds.

As passive management, index funds, and ETF’s grow in popularity grow the distinction between active and passive management is become much less clear.  These specialized funds and closet active manager’s offer specialize products sold as “index funds” or “ETFs” to capitalize on popularity of these investment vehicles and charge still higher management fees.  Despite the fact that index funds generally offer a greatly reduced cost to mutual funds, index funds come in many different fees and it important to understand what you are paying. 

Fees on index funds can still be substantial for investors with large portfolios, especially considering the length of time an investor anticipates holding an index, and how cheap it is to buy and sell stocks individually. 

A major issue with traditional capitalization weighted indexes is portfolio construction.  Traditional capitalization weighting, by definition, gives additional weight to stocks that are currently overpriced relative to their fair value and reduced weights in stocks that are currently trading below that true value.  The mismatch of buying too many overvalued shares and too few undervalued shares leads to performance drag in cap weighted index funds.

As index funds have grown in popularity and now account for a large portion (~30%) of the market, the rebalancing of an index can impact the stock price of the impacted companies.  A company being added can have a demand shock leading to a price increase, and a company being deleted can have a supply shock, leading to a price decrease.  Increasingly, short term traders anticipate these moves and trade ahead of these stock price moves.   This results in profits transferred from index fund investors to short term traders, estimated to be at least 21 to 28 basis points annually for S&P 500 index funds, and at least 38 to 77 basis points per year for Russell 2000 funds.

The fact remains that some managers outperform passively managed portfolios over long periods of time.  These manager can avoid some market segments are less efficient in creating profitable investments.  Skillful investment managers can avoid overvalued securities and overvalued markets. In addition, a skillful manager can also reduce volatility by investing in less-risky, high-quality companies rather than in the market as a whole.

Despite the surge in popularity of index funds, these investment vehicles may offer lower costs (lower investment fees and transaction costs), but index funds are far from perfect.

Scout Investments offer comprehensive investment, insurance, and mortgage solutions at the lowest cost to our clients. 

kevin@scoutinvestment.ca          www.scoutinvestments.ca              1-800-795-6701