See Forest

Passive Investing: Seeing the Forest For the Trees

See Forest

Sometimes it is hard to focus on the big picture, often getting caught up in the minutia where we are expending our efforts for little benefit in return. Other times we lose sight of the purpose of our efforts in the first place. In other words, we forget to ask the question “why” and simply accept something at face value. This seems to be a common trend among fund companies who are starting to pursue passive investment strategies.

The evolution of passive investment strategies has been quite impressive since the launch of the first index fund in 1971 by Wells Fargo Bank. Fund companies like Vanguard, which is now the largest mutual fund company in the world, and Blackrock have become the industry leaders in delivering index-based solutions for investors.

There have also been enhancements made to the original intent of the index fund. The original pioneers of index funds came from the premise that accepting market prices rather than fighting against them was a much more profitable strategy based on decades of historical evidence from data as well as practical examples in the professional money management industry. Thinking beyond the simple rules of index tracking, which is still the most common way of implementing a passive investment strategy, some industry leaders, like Dimensional Fund Advisors (DFA), have been able to create more value for their investors; all with a steadfast aim of the original premise of passive investment strategies.

A recent article in Bloomberg highlighted some of the pitfalls in following a simple index-tracking approach to passive investing. As a quick reminder, simple index-tracking is buying securities within an index at the same market-cap weight of those securities within the index trying to keep the difference between the index and the strategy at a complete minimum. The aim is to minimize tracking error as much as possible. The authors of the article referenced a study conducted by Winton Capital Management Ltd., a quantitative hedge fund based out of Great Britain, which concluded that strictly adhering to traditional rules of index tracking cost investors in those specific index funds 0.20% per year, or $4.3 billion in lost income, from 1990-2011. How could this be?

The answer has to do with active traders front running the reconstitution of the benchmarks like the S&P 500 or the Russell 2000. Indices will publicly announce the changes to their indexes well in advance. Fund management companies that follow a strict adherence to index tracking, will have to buy or sell securities on a specific date (the reconstitution date) in order to maintain that minimal tracking error that they seek. Subsequently, active traders can front run those index funds by either buying into securities that are added to the index or selling securities that are going to be removed from the index. By no means is this activity illegal since information is publicly disclosed to all market participants.

But, it does beg the question of intent of adopting a passive investment strategy. Following the original premise that we accept market prices does not mean that we have to give up performance in order to maintain a minimal tracking error. Noticing this obvious pitfall in traditional index tracking, DFA looked to find a better way. By adding a more flexible trading approach to their investment strategies they were able to boost performance. Of course they had to accept some form of tracking error, but the intent is not to minimize tracking error, but gain a cost-effective exposure to a specific segment of the market.

IFA recently published an article highlighting the reasons why we partner with Dimensional Fund Advisors. It is not simply because they build passive investment strategies, it is because they are willing to ask the question “why.” Their culture of using evidence to create practical solutions based on time-tested data is the driving factor behind their value as a firm. It is not the products they produce, but the process in which they produce. That is what gives us confidence that our investors can sleep well at night knowing that their backs are covered.