Is It Active or Passive?

As was widely expected, the Federal Open Market Committee raised interest rates by a quarter point (0.25%). Whenever there is action by the Federal Reserve, bond experts are often turned to for their views on navigating the credit markets. Their insights clearly reflect active investing, but what if an investor were to use their opinions to choose a bond index fund to invest in? Is such behavior active or passive investing? Taking it a step further, what about an index designed to weight bonds based on the characteristics active fund managers seek out, such as interest rate sensitivity and credit quality? Would you consider an exchange-traded fund (ETF) mimicking such an index to be passive or active? (Aye Soe of S&P Dow Jones Indices thinks such “smart beta” ETFs could be launched over the next few years.)

This question about the gray area between active and passive investing was discussed at a CFA Society Chicago event held earlier this week. Much of the conversation focused on factor investing, and its close sibling smart beta. Factor investing involves targeting securities with specific traits such as value, small size or low volatility. Focusing on such traits was previously in the dominion of actively managed funds. The growth of ETFs has lowered the costs of getting specific exposure to these traits.

Most ETFs track indexes. Indexing is considered to be the key part of passive investing. The purest form of indexing is a mutual fund or ETF tracking a broad and well-established index. Examples include the S&P 500 and the Barclays U.S. Aggregate Bond index. Factor and smart beta funds track more specialized indexes.

These specialized indexes are completely unknown to the general public. They are also the result of analyzing past data to find quantitative traits associated with higher returns. Such product launches can be summed up in a longstanding Wall Street observation: “There’s no such thing as a bad backtest.” The observation refers to the fact that the only strategies investment firms introduce are those with good historical performance. Nobel laureate Eugene Fama shared a similar observation at the Tuesday event, saying “academics only publish what works… [they are] only interested in things that are robust.”

Fama’s comments were noteworthy because he and his research colleague, Kenneth French, are famous for their three-factor model explaining the key drivers of stock returns. They have since expanded their model to five, adding profitability and investment pattern to size, value and an adjusted excess return over a risk-free asset. (Fama revealed that he would like to simplify the model by dropping one or two factors, but he’s not sure which ones to exclude.)

Many in academia and in the investment industry have built upon Fama’s and French’s work. Fama cited one study as finding the existence of 386 factors. Tracking them in an ETF is a form of passive investing, but what about the decision to create the index that the ETF is based on? How about the decision to target a certain factor? Is it still passive investing?

The answer arguably falls into a gray area. Tracking an index is a passive approach. Choosing to create an index or to deviate from a market portfolio by investing in factor (or smart beta) funds is an active approach.

It can be a costly active approach at that. Even the most persistent factors incur periods of underperformance. Plus, the investment industry tends to focus on what has done well lately. Some of you may remember Munder Capital launching its NetNet mutual fund in the 1990s to target dot-com companies. (The fund no longer exists.) Joel Dickinson, the global head of investment research and development at Vanguard, said he’s seeing similar forms of performance chasing occurring in the indexes and ETFs that are launched.

Actively choosing well-established factors to target and then passively following the strategy can produce good long-term results. The danger is when one jumps from one factor to another in search of performance. Fama expressed his thoughts on such approaches by opining: “Forget timing factors, that’s ridiculous… timing is more subject to error than security picking.”

SEC Seeking Input About Broker Conduct

The Securities and Exchange Commission is seeking comments from individual investors about standards of conduct brokers and advisers must be held to when providing advice. Scroll to the bottom of the page on the SEC’s website for instructions on how to share your thoughts.