The Myth of the Passive Investor

by Patrick Rudden, AllianceBernstein

Some investors have such little faith in the merits of active management that they prefer to take a 100% passive approach. We think they may be making more active decisions than they realize.

Those who go passive know why they’re doing it. Instead of paying active managers to try to select securities to beat a particular index, they’ve decided to hire managers to track that index. Yet this approach involves several active choices.

First, passive investors must decide how to allocate their assets. A US investor, for example, might decide to be 50% in US bonds, 25% in US equities and 25% in international equities. Next, passive investors must choose which indices they want tracked. Our US investor might select the Barclays US Aggregate Bond, the S&P 500 and the MSCI EAFE indices respectively.

So far, so straightforward. But getting to this point has required a lot of active decision making. The important decision about how much to allocate to bonds versus equities is an active choice. And so is the decision about how much to allocate to US versus non-US stocks.

Who decides what?

In the case of US equities, by choosing the S&P 500 as the index to track, our investor has outsourced stock selection decision making to the S&P committee. This committee actively selects the 500 companies that it believes most accurately represent the US economy. The committee’s periodic announcement of which stocks are being added to, and which stocks are being deleted from, the index creates investable price anomalies.

Investors who don’t track the benchmark can profit from not taking the closing prices on the day the index is reconstituted. Indeed, investment banks have historically had units focused on capturing the profit from going long a basket of index additions and short a basket of index deletions.

Active decisions are also unwittingly being made in non-US benchmarks. By selecting MSCI EAFE as the index to track, an investor has chosen to exclude smaller-cap stocks and the stocks of companies listed in emerging markets. MSCI also appropriately makes active decisions about how it will build its index, including how it best represents the equity opportunity. For example, MSCI determines the classification of countries as emerging or developed—this can create substantial differences versus the classification by other index providers like FTSE.

Choices, choices, choices…

When it comes to selecting a passive manager to track the index, there are further choices to make. Does the manager attempt to fully replicate the index or not? If fully replicating, does the manager have leeway to trade intelligently around index reconstitutions? Taking the closing price on the day the index is reconstituted will minimize tracking error, but comes with an opportunity cost. If the manager is sampling, rather than replicating, an index, what is the sampling methodology?

Some investors don’t believe they can successfully identify stock pickers on an ex ante basis. Therefore, they—quite rightly—choose not to do so.

But passive investing may be a misnomer. Asset allocation and index selection are important active decisions. And so is the decision about how a tracking manager will track. So investors should recognize when they are making active decisions that are likely to have a significant impact on their investment outcomes—and think carefully about the choices they make.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.

Patrick Rudden is co-manager, Dynamic Diversified Portfolio at AllianceBernstein (NYSE:AB).

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