Why passive investing and index tracking are not the same thing

Rob Davies of Maven Capital Partners looks at index trackers and finds they are not always as passive as you might think, and that passive investing does not always mean index tracking.

Trying to describe a passive, index or tracker fund is a lot harder than it might seem.  Take a look at some excerpts from descriptions, by the managers, of a number of funds that are widely regarded as falling into this category.

“… closely matching the performance of the FTSE Actuaries All-Share Index. The Authorised Corporate Director (ACD) will aim to hold securities that represent the FTSE Actuaries All-Share Index  “

“Generally the Fund intends to purchase a broad and diverse group of readily marketable stocks of United Kingdom companies traded principally….”

“To closely match the performance of the FTSE actuaries All-Share Index on a capital only and total return (after charges) basis.”

“seeks to track the performance of the index”

“aims to provide long-term capital growth by matching the return of the FTSE All-Share Index by investing in….”

And so on……

Two things stand out. They use words like aim, closely and seek, and they fail to describe exactly how they intend to achieve their objectives.

Index trackers are not always entirely passive

It is clear that none of these funds expects to exactly match the index they are tracking. That is because of factors such as new issues, takeovers and holding un-invested cash, or perhaps a lack of liquidity with some of the small stocks near the bottom of their respective indices.

These complexities mean the managers must exercise at least a modest degree of subjectivity to address these points, and maybe even use derivatives to help out.

More important though is how these funds are managed. It is clearly not the case that they just buy the index and leave the market to do the rest. At the heart of this matter is the differentiation between the process (passive investing) and the measure (a market index).

Passive investing does not have to mean index tracking

The process is to invest using a set of rules that could be interpreted by any qualified finance professional, rather than a feeling in someone’s water.  That is the passive investing process.

Since it started in the mid-seventies the default assumption is that passive means allocating capital according to the market capitalisation (market cap) of a company in relation to that of the index as a whole. In other words, the measure used to allocate capital to a company in the index is the price of that company.

This made sense in the early days of indexing when company accounts were rudimentary by today’s standards, but modern financial statements are far more detailed and enable analysts to get a much more thorough understanding of the company.

Even so, there are essentially only four ways to fundamentally measure the size of a company; by sales, by book value, by dividends and by profits.

Some argue that weighting based on the market cap is the only true way to run a passive fund. That’s because it uses the same measure as the index and is therefore the only mechanism that permits fluctuations in the market to be reflected in the fund without any dealing activity.

Managers who advocate using other measures would counter that this confuses the process (passive investing) with the measure (a market index).

Investors might wonder why there is a need to use any measure other than mkt cap for a passive fund. After all a passive fund will hold all – or virtually all – of an index. The question is in what proportion?

Here, Oscar Wilde’s famous quip that “nowadays people know the price of everything and the value of nothing” seems relevant to mkt cap-based funds.

Passive investing using fundamentals rather than market price

Using a fundamental rather than a price-based measure to allocate capital does not invalidate the passive process. Arguably it provides the only possibility for a truly passive approach to beating the market.  It just does it in a different way.

It is perfectly possible to allocate capital by any one of sales, book value and so on, in a passive manner, i.e. following a strict rules-based process. There is plenty of evidence, from Warren Buffet downwards, to tell us that portfolios with a bias to value do better over the long term.

That makes sense as essentially managers are investing in anticipation of a stream of earnings and, as with everything in life, buying something cheaply usually gives a better return on that capital.

A passive fund is simply one that follows a process, regardless of how it is defined, and irrespective of the measure employed, to invest in all, or the majority, of the constituents of an index with the absolute minimum amount of subjectivity.

John says: I find this topic of fundamental-based passive investing interesting because I consider myself to be about 80% passive, i.e. 80% of my approach follows a strict set of rules. I’m also entirely focused on maximising fundamentals like earnings and dividends rather than market cap.

The active 20% of my strategy is for situations where qualitative analysis is more useful than quantitative, and to give me some discretion over the decisions I make.

So there is a sliding scale between passive and active, rather than a gaping divide. 

A 0% passive portfolio, for example, would be built in an entirely ad-hoc approach, with no underlying strategy or rules whatsoever, while a 100% passive portfolio would adhere strictly to a pre-defined set of rules.

But those rules would not have to match the rules of a market cap-based index. The rules could simply be to invest equally in 10 stocks picked at random each January 1st by throwing darts at the Financial Times. That would be passive, but it would not be index tracking.