Indexing—meaning attempting to replicate or track a benchmark index’s performance—is a form of passive investing. However, not all passive investing is indexing. According to the Charted Financial Analysts Institute, passive investing is any rules-based, transparent and investable strategy that does not involve identifying mispriced securities.
A strategy might select publically traded stocks that score highly on ESG criteria. There would be rules to follow, and if disclosed, the process would be transparent. This strategy does not attempt to identify mis-priced securities, only their adherence to the theme; thus, it would be passive, yet it does not track a benchmark.
Vehicle running costs
For clarity, it is worth exploring the difference between an investment strategy and an investment vehicle. A strategy, be it passive or active, will determine which stocks end up in a portfolio. Investors gain access to the portfolio via an investment vehicle.
Open-end, closed-end and exchange-traded funds (ETFs) are types of investment vehicles. Investors buy shares in an open-end fund from the fund itself. When investors what to sell, the fund redeems the shares. Shares are priced daily at net asset value (NAV). Summing the product of all securities held and their closing prices determines the NAV.
A closed-end fund raises capital by issuing shares and selling them to investors. Investors buy and sell shares from and to each other, typically on an exchange. The market determines the price of shares in closed-end funds.
ETFs trade on exchanges like closed-end funds. Instead of issuing shares to investors in exchange for capital, ETFs pass newly minted shares to a broker/dealer firm in exchange for a basket of securities the ETF wants to own. The broker/dealer is then free to sell the ETF shares in the open market.
The structure of the investment vehicle may make some investment strategies problematic. For example, an open-ended fund has to generate cash from its portfolio to pay redeeming investors. It might have to hold a cash balance to meet redemptions. But if investors redeem at a rate that exhausts the cash balance, assets will have to be sold to generate cash. If the fund invests in small-cap stocks, or private equity, raising money will be tricky.
Open-ended funds might not want to track an index because of the need to hold cash. Since cash does not earn a market return, it is a drag on the funds’ ability to track an index’s return. But an open-ended fund is not necessarily prohibited from implementing a passive strategy. ETFs can follow an active strategy.
The price is right
The efficient markets hypothesis claims that markets fully, accurately and instantaneously incorporate all available information into market prices. According to the efficient markets hypothesis, it is not possible to buy undervalued stocks, or sell overvalued ones, thus trying to identify mis-priced securities is folly.
Active investment strategies try to outperform benchmarks. In many cases, the benchmark is a stock market index, like the S&P 500 or the FTSE 100. Although a benchmark can be almost anything, and even custom made, it does have to represent the options available to a particular strategy. For example, a fund that invests in small-cap growth stocks should not choose a large-cap benchmark to judge its performance.
A portfolio has to differ from a benchmark to beat it. Increasing the portfolio weights of stocks that do better than the benchmark return is one way to outperform. Another is underweighting (including not holding them at all) stocks that do worse than the benchmark average.
How to find those stocks that will outperform? An active investor will be looking for mispricings, and underweighting overpriced securities and overweighting undervalued ones. But according to the efficient markets hypothesis, this is not possible. Since active funds incur costs to identify mispriced securities, above those to track an index, they are already behind. Since there is nothing to be gained from identifying mispriced securities, they are behind for nothing. Investors pay more for active funds, and it would seem then they are paying for nothing.
There are various forms of the efficient markets hypothesis and plenty of interpretations. But there is compelling evidence that the so-called semi-strong version, which would render technical and fundamental analysis as incapable of generating positive risk-adjusted returns consistently, is correct.
But the whole hypothesis turns on the assumption that the price is right. The question is, how it can be?
Paradoxical returns
For a stock price to be correct, it should be equal to the stocks intrinsic value. To find the intrinsic value someone has to estimate future cash discount them back to the present at a rate that properly reflects the cash flows’ riskiness. Valuing a stock requires effort. But the efficient market hypothesis suggests that identifying mispriced securities is folly. So, why would anyone bother? Yet, if no one bothered, how can stocks and markets fully, accurately and instantaneously incorporate all available information in their prices?
Sanford J. Grossman and Joseph Stiglitz introduced this paradox to the investing world in 1980. It is indeed a headscratcher: why would anyone bother to do something that has no benefit to them? But, we know that market participants are behaving paradoxically. Intrinsic values are being calculated — for example, by sell-side and buy-side analysts — and stocks are being bought and sold based on those values.
Analysts receive compensation for their valuations that is not contingent on the valuation being “right”. It would be the ones paying for the valuation in one way or another that are behaving paradoxically — if indeed they are — if they make decisions based on those valuations. The efficient markets hypothesis says that they can not generate superior risk-adjusted returns by identifying mispriced securities.
Perhaps passive investors should be grateful to those active investors because they spend money to make the markets efficient, yet get nothing in return. But the efficient markets hypothesis can be extended to say that active investors cannot generate superior-risk adjusted returns, after deducting the costs of gaining the information required to identify mispriced securities. But that would mean active investors still might as well be passive ones because they are only breaking even, despite putting in more time and money. And if they did all become passive investors, then how could the markets be efficient?
Everyone is indexing
What would happen if everybody was a passive investor? In particular, what if everybody just tracked an index passively. All these investors sell if they need cash. They will not sell because they think the index is too pricey, nor buy if they feel it’s cheap. They invest when they have the cash, and make no judgement about it being the right time or not.
If all these passive investors are using ETFs or closed-end funds, they are selling or buying shares in the vehicle to each other. The underlying portfolio should not change, and thus no shares in the index are sold. If an ETF creates new shares to sell to investors or a new open-ended fund pops up, there will be activity in the underlying index shares. Ditto is an ETF retires shares or a closed-end fund shuts up shop. But these events will transact at the market price from the funds perspective, and usually at the closing price for the day.
Open-ended passive funds might provide a degree of volume since they have to buy and sell shares every time an investor gets in or out. However, this activity again is usually done on the market close. If everyone is submitting buy and sell orders on the market close, and only when an investor wants in or out, or a fund is retiring or creating shares, what determines the market close price? If there is hardly any volume throughout the day (because everyone is passive remember) what would become intraday prices?
Would it be the case that index prices, as a whole would only drift higher over time if, in the long run, more people were making their first investment compared to those pulling money out of the market as say, they retire. Or would price stall completely? It’s hard to imagine a world where market order books are empty save for a flood of orders aroun5 pm. Would markets break down if everyone was passive?
The Storied Investor 