What is passive investing?
Passive investing has grown rapidly over the past two decades and is now widely seen as a simple, low-cost way to invest. But while it’s often described as “set and forget,” the reality is more complex.
In this article, we explain how passive investing works, why it isn’t as passive as it sounds, and what this means for investors choosing between passive and active strategies.
Passive investing once meant simply copying a market benchmark by owning the same stocks in the same proportions as the benchmark.
How market indexes work
The most widely used benchmarks are based on company size, known as market capitalisation. The most well-known index, the S&P 500, tracks the 503 largest companies in the US (the extra three are due to dual listings like Alphabet A and B shares).
The largest company is Nvidia, with a market capitalisation of $4.2tn, representing 7.12% of the S&P500 Index. That means for every $100 invested in an S&P500 passive index fund, approximately $7.12 would be invested in Nvidia shares. The second largest company is Apple at 6.18%, meaning $6.18 of every $100 invested would be allocated to Apple, and so on.
The 100th largest stock, McKesson Corporation, represents just 0.18% of the index, and by the time you reach the 186th largest company, Sempra, only 10c of every $100 invested would be allocated. There are only 15 stocks which are larger than 1%, while 316 companies each represent 0.1% or less.
The smallest company in the S&P 500 index is News Corp, with a market capitalisation of US$13.98bn (NZ$24.10bn), still larger than NZ’s biggest listed company, Fisher and Paykel Healthcare at NZ$21.5bn. Overall, the S&P 500 accounts for approximately 80% of the US share market measured by market capitalisation.
Why passive investing isn’t truly “set and forget”
While passive investing may conjure the concept of a ‘set and forget’ portfolio, indexes are not static. Using the S&P 500 as an example, adjustments take into account factors such as free float and industry classification.
Free float considers only the shares that are available to investors, rather than a company’s total outstanding shares. Float adjustments exclude shares held by other publicly traded companies, government agencies or certain types of strategic shareholders.
Industry classification adjustments are based on the “Global Industry Classification Standards” (GICS). This system was developed in 1999 by S&P Dow Jones Indices and MSCI to establish a global standard for categorising companies into sectors and industries. It is comprehensive, consisting of 11 sectors, 25 industry groups, 74 industries and 163 sub-industries.
These classifications are actively maintained to adapt to the changing investment landscape. As the global economy evolves, sectors, industry groups, industries and sub-industries can be added or refined. GICS categories are used to ensure the index represents industries and sub-industries in proportion to their share of the total market.
Indexes are constantly evolving
The S&P 500 committee meets monthly and rebalances quarterly. Changes to index composition are announced a week or two in advance, and index fund managers must decide how to buy the shares of companies being added, and sell those being removed.
This has typically resulted in share prices rising when companies are added to the index and falling when they are removed, although that effect appears to be shrinking over time.
Not all index funds will make all of those trades simultaneously. They will have some leeway to transition over the course of a few days and possibly months, at their discretion.
Interestingly, in New Zealand back in the early 2000’s, prior to the sweeping tax changes in October 2007, index funds were exempt from capital gains tax because they were ‘passive’. In contrast, other equity funds were considered active because they ‘traded’ stocks and were therefore taxed on realised, and essentially also unrealised capital gains.
However, when Vanguard applied to the IRD to approve its S&P500 index fund for the tax free status in New Zealand, the IRD ruled that, due to the way they actively managed index changes, it could not be considered truly passive and would instead be treated as traders for tax purposes.
Strictly speaking, the IRD was right. Vanguard, however, believed it had an edge over competitors in managing index changes and could eke out a few basis points of performance, helping to offset their fees and more closely track the index.
The S&P 500 is a dynamic index, with changes occurring every quarter, and rules governing intra-quarter events such as stock splits, M&A, dividends, takeovers, capital raises and the like. Faster-growing companies are added over time, and new categories created to accommodate emerging industries, replacing declining and disrupted industries. It is categorised as passive, but it is not inactive!
The rise of ETF’s and rules-based investing
Over the past 30 years, passive investing has mushroomed to cover almost every market, sector, style, region, factor, and fad that you could imagine. The term passive is synonymous with ‘rules based’ investing, meaning each product is defined by a set of rules, just like the S&P 500 index. These rules determine every trade, and once established, there is no human intervention, timing or interference in the process.
This phenomenon has been largely enabled by the ETF (exchange traded fund) structure which provides low cost and easy access via a listed exchange, offering daily liquidity. There are now more ETF’s than stocks, with some estimates up around 15,000 ETFs, and more than 10,000 of those rules based.
Just as with the rules behind the S&P 500 and the funds that track it, we find the same dynamic processes defined by these passive ETFs. These days there are ETF’s which apply rules previously associated with active management. Filtering companies for return on equity, balance sheet strength, management, insider ownership, dividend history, volatility, price to earnings, and many other metrics commonly used by active managers, can be hard coded into a systematic strategy. As a result, you can now find an ETF for almost any theme or concept imaginable.
Many offer leverage, like 2 or 3 x the return of the Nasdaq 100, or even 2x single stocks like Nvidia, Super Micro Computer, Tesla or niche mining companies. The TTT’s provide 2x short the global bond index. Investors can own a gold ETF, or short gold via an ETF.
The irony at the heart of passive investing
What I find fascinating about these subsets of the share market is that using them is in itself, an active choice. Investors have to believe that by selecting one or more of these rules-based funds will deliver a better outcome than simply holding the whole market.
And therein lies the irony.
At the very core of the index fund revolution is the idea that it is very difficult, arguably nigh on impossible, to consistently beat ‘the market’ over time. Yet the very existence of this plethora of sub-set indices only exists so investors can actively choose between them, presumably with the intention of beating the broad market.
Passive these funds may be, but their real utility sits within an active mindset, where investors decides to stray from the ‘whole market’ and select a subset.
How these tools are used in practice
In our world of alternatives and hedge funds, managers do use ETF’s for certain thematic tilts and for hedging purposes. This seems like their best use case. However, I am left wondering how much benefit is being garnered from the vast majority of these products, other than of course to the issuer!
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