Apr 06, 2016

Are Index Funds and Passive Investing Really So Great?

By Bobby Monks and Kathleen Campion,

Index funds and passive investing have revolutionized the investment world and provided a strong challenge to actively managed funds. But as we’ll explain, index funds aren’t perfect and could become threatened by an even newer investment paradigm.

Investors have been voting with their money in favor of passively managed stock and bond funds. In January, Morningstar reported that investors pulled $139.5 billion from actively managed U.S. stock and bond funds in the first 11 months of 2015 while adding $361.8 billion to passively managed stock and bond funds. A good share of that money fled to index funds. This was not a flight to safety, you understand, just a flight from overcharging, underdelivering active managers.

In 1975, when Jack Bogle, the pioneer of passive investing, introduced what was arguably the most significant change in investor options in a generation — the index fund — his revolutionary idea grabbed the financial industry’s pricing structure by the throat. Bogle passively demonstrated the financial sector was systematically taking advantage of the individual investor with hidden, conflicted and soft-money fees.

By definition, an index fund cannot underperform the index it tracks. When active managers do underperform a broad benchmark like the S&P 500  (^GSPC) , they look inept and scramble to justify the rich fees they’ve been banking. The justifications for hands-on management are familiar, if unconvincing.

There’s plenty of defensive chatter about strategies and pricing models, but ultimately, if the Vanguard 500 Index Fund (VFINX) beats all that modeling and the expertise of the active manager and costs a fraction of his fee, index funds look almost sexy. Hedge fund manager Bill Ackman noted grudgingly, “Last year, index funds were allocated nearly 20% of every dollar invested in the market.”

So it is not just retail investors with 401(k)s who are seeking safe harbor in the index funds. A Wharton study released last April says institutions such as pension funds are big players. The study showed that by October 2014, index funds held $3.2 trillion in assets, or 36% of assets in funds owning U.S. stocks.

Clearly, a substantial cohort of investors has stopped chasing this year’s Jesus, the smart guy in the Paul Stuart suit who outperformed last year and might again; or the millennial darling — robo’s dispassionate embrace. Instead, they’ve given up and simply rolled the portfolio into an index fund or two or three and headed for the beach.

But hang on a minute. Passivity as a strategy rankles. It’s really a nonstrategy, an I-give-up-strategy. No less a visionary (though hardly a capitalist) than Mao Zedong warned: “Passivity is fatal to us. Our goal is to make the enemy passive.” Setting aside who might be the enemy in our investment scenario, what are we missing about the index fund as an ideal way to make and conserve capital?

To begin with, there are thousands of indices and therefore thousands of index funds tracking them. How do you choose? If you have to do all the research, you have become your own active manager. Few of us have the time or, more importantly, the expertise.

Also, markets by their nature move up and down, sometimes with a staggering chop. Who gets you out before a meltdown and back in when things settle down? That would be you again as there is no one to call. Of course you can limit the downside risk by hedging your bet; you could short the index or buy puts. Again you have become the active manager, and you probably have a job.

And who manages tax ramifications? For example, if you sold your house this year at a nice profit, also known as a capital gain, you might like to take some losses in the stock portfolio to balance that out. You can’t just sell your losers in an index fund to offset the capital gain exposure. You are in or out, so passivity can cost you here.

The broader tax problem is one you never see. Index funds, owing to the constant rebalancing, require buying and selling without considering tax exposure, and that tax burden is passed through to the investor on the record date.

Investors who warm to so-called ethical investing will have limited choices in indices. Can’t stomach Halliburton or Coors or Exxon Mobil? That leaves you out of the big indices and again leaves you actively managing your investment choices. You can do it. Market leader Vanguard offers the Vanguard FTSE Social Index Fund  (VFTSX) , and there are more than one hundred others, but it is a relatively short list.

Ethics aside, there are also the mechanical disadvantages that a passive instrument imposes. Critics point to the constant rebalancing necessary to keep the index fund reflecting the index. This means the fund is “always in the market” and, so always paying commission and transaction costs.

“Cash drag” is another issue. The index fund must hold cash to deal with potential daily net redemptions. So, index fund investors may pay less for someone to hold cash, but they do pay someone to sit on cash.

The reporting can be dodgy on both passive and active funds. That’s because regulators require some specific disclosures while allowing a certain opacity on other fees. In practice, investors have a poor shot at understanding what they are paying managers, even passive managers.

Finally, the pièce de résistance of the passivity problem is proxies. Shareholders have the opportunity to vote on a raft of issues concerning the corporation, things like trimming the compensation package of an underperforming CEO, or supporting a share buyback or opposing a diminished dividend. “Proxy access” is 2016’s hot button issue. The ability of shareholders to propose board members for companies in which they invest would seem a no-brainer.

But data from Fund Votes, a proxy research firm, demonstrate the funds use shareholder proxies to support current management: “On director elections, large fund groups vote with management on average between 93% and 95% of the time … across the S&P and Russell 3000.”

There is a conflict of interest here as the fund managers doing the voting are looking for more business from the management they are supporting. It is in their interest to “check the box.”

It has been 40 years since Jack Bogle’s simple idea changed the investment landscape. He summed it up in a recent Money magazine interview: “Look, all I did with the index fund was make sure you got your fair share of the market’s return.”

His “fair share” has a modest price tag relative to the other 50 large fund groups because Vanguard is owned by its own funds and profits are returned to those owners. Bogle’s brilliant idea wasn’t just dropping the fee; he eliminated the middle man, which he sees as the worm in the apple: “The conflict of interest in the industry isn’t about indexing vs. active management. It’s cost. The point of the Vanguard structure is to eliminate the management company’s profit.”

Like all good ideas, it was simple to begin with, though today Vanguard is taking an ironic turn. The firm now has more than $30 billion under management in its new Personal Advisor Services business, which is focused on providing personalized advice to baby boomers. Joe Duran at Investment News notes Vanguard: “…has its sights set squarely on the advice industry.”

And that new Vanguard business hints at the paradigm shift that’s about to transform the industry. We’ll explore that in depth in a future article.

The article was originally published by TheStreet.com on March 29th, 2016.