When clients ask me, ‘How are my investments doing?’ or ‘What’s the performance been?’ it’s always important to ask first, in comparison to what? Value judgments for these kinds of questions need a benchmark, or standard, against we hold the results to measure. For some things the standard is zero; maybe when considering the interest rate on a savings account, or possibly you may be interested in the rate compared to an inflation measure, such as the Consumer Price Index (CPI). You may even have a simple fixed rate of return you are comparing to, such as 3% per year.
Other investments you might measure against similar investments, so how does a Term Deposit look compared to savings accounts, or a Bank Bill compared to a similar length Term Deposit? For listed shares, it has become the norm to compare, or benchmark, how individual stocks or large portfolios perform relative to an Index, like the S&P/ASX 200 for a diversified portfolio of Australian Shares.
Some of these indices date back over a century in the US, with measures like the Dow Jones Industrials Average (DJI) first established in 1885, however indices have changed quite a bit since then, especially once the use of computers to track overall share market movements became possible. More meaningful indices such as the Standard & Poors 500 (S&P 500), which tracks the top largest 500 listed companies in the United States as measured by market capitalisation (or size for want of a simpler description), started to appear in the 1960s.
In Australia the equivalent index was the All Ordinaries Index, which covered the top 500 largest Australian listed companies, but has generally been replaced by the S&P/ASX 200, as outside the top 200 stocks you are getting into some very small companies.
Which brings me to my central question, what is ‘passive’ investing and how passive is it really? Well, Passive Investing, often used interchangeably with the term Index Investing, is where you invest in a portfolio of assets (usually shares, but this can often apply to other asset classes like bonds) that match as closely as physically possible, a chosen Index.
Passive investing uses generally only traditional, market-capitalisation (size) weighted indexes. This is an essential point in this discussion, because indices don’t have to be market-cap weighted, it’s just that historically this is what we have decided is the best representation of the default, un-adjusted view of the share market as a whole.
This is interesting because some of the first indices, such as the DJI, were simply measures of changes in share price of a basket of the 30 biggest companies, not changes in overall company value, or market capitalisation.
To get the market cap, or size, of a company, you need to multiply the share price by how many shares are on issue. A company with 10,000 shares worth $100 each is worth $1 million, a different company with a million shares on issue, but with a share price of only $1 is also worth $1 million overall.
So share prices on their own can be deceptive. If the share price falls 10% because a company has issued (created) an extra 10% in shares (without getting any new money for it, say as a director’s bonus), then the value of the company hasn’t changed, but the share price has. So simple share price Indices have their drawbacks, but all Indices do, it’s just some we accept as minor and others we can’t avoid.
So why might these passive investment portfolios, built from copying blindly ‘the index’, not be truly passive? Let’s focus on the Australian share market for the moment, and taking the most widely accepted benchmark Index, the S&P/ASX 200, this index is comprised the top 200 largest (by market capitalisation) listed companies on the Australian stock market.
But there are some significant caveats to this; ‘largest’ is adjusted for ‘available float’, so if a company only has 50% of its shares available for trade (with the other 50% held by a private investor or other parent company for example), this can affect it’s weighting or even inclusion in the index. Other considerations include liquidity and tradeability, company stocks must be ‘institutionally investible’, so very low turnover or illiquid stocks, don’t get included because they are not practically investible by institutions.
This is very important because these excluded companies do exist and in reality form part of the investible universe for the average person on the street, regardless of how attractive (or unattractive) they are from an investment perspective. Other considerations such as if the company is undergoing part of a merger or acquisition can find them excluded from the calculation of the benchmark. These calculations of the composition of the index are usually done each quarter, introducing a large timing factor, especially considering that the real world market trades almost every business day.
But the biggest factor on the nature of index investing is the weighting to size, or market cap. If you take all the 200 companies included in the S&P/ASX 200 and added up their individual market caps, then how much weight each company has in that index is based on their proportionate size compared to the market as a whole.
So if, for example, the Commonwealth Bank of Australia (CBA) market cap is 7.5% of all the top 200 companies in the index combined, then the Index would weight CBA to 7.5%. Any change in CBA’s share price would affect the S&P/ASX 200’s performance by 7.5%. In fact, just the top 10 stocks in the index represent around 45% of the entire S&P/ASX 200 index, putting a lot of influence over the ‘market index’ by just 10 companies. Now this may be saying a little more about the size of the Australian share market than about indexing generally, but it relates to my next point.
As companies grow in size within an Index, if you are ‘passively’ following the index, the weighting of that company in your portfolio is allowed to grow. You never ‘take profits’ on that specific stock. This is not to my mind a ‘passive’ decision, it is an ‘active’ investment decision whereby you are choosing to continue to invest in a rising stock. You are just doing it automatically, following the Index ‘rules’. If a fund manager or investor was to do this outside of following an index, it is called a ‘momentum’ play, where you hope to benefit from the continued rise of a share’s price over time.
This also works in reverse. As a company stock falls in value, you allow it to fall in value within your portfolio, you do not ‘re-balance’ or ‘top up’ (some might say ‘throw good money after bad’), and eventually if the stock continues to perform poorly, they will get dropped from the Index. When this happens the passive investor sells their stock, but again, this is not really a ‘passive’ investment, you are actively deciding to sell based on the rules of the index. A non-index investor (labelled active investor by the finance community) may continue to hold that stock indefinitely, or at least until it goes into liquidation.
So the ‘passive’ investor isn’t so much being passive, as they are following a prescriptive set of investing rules that are laid out by how their chosen Index is constructed. Traditional indexes that seem to be allowed to call themselves passive are ones set around market-capitalisation weighted, with minimum free float, liquidity and other constraints. These rules are an ‘active’ decision on what constitutes the Index.
Many other rules can be used to make up Indices, and these alternative Indices can be used to make up Index-following, or ‘passive’ investments. But these new breed of Indices and Index-tracking investments have not been allowed to use the moniker of ‘passive’ investing; though many don’t want to anyway (everyone needs a point of difference, don’t they?). These alternative Indices are typically called smart-beta, or the term Factor investing has become popular, but are simply different sets of rules for making up an Index than the older, market-cap weighted indices.
Remember, we only really used market cap as our starting point for creating a ‘market index’ because calculation-wise it was very easy. But with powerful computers and massive sets of information-rich data available beyond a simple share price today, more meaningful rules can be used to construct an Index.
I delve a little more into these smart-beta (or low-cost active as I prefer) themes, at least in relation to size, in a previous article ‘Does size matter?’.
Ultimately I am not arguing against ‘passive’ investing, far from it – just read one of my previous articles “The positive side of being passive” – but I also don’t want people to limit themselves to just market cap weighted Indices. These Indices are not really ‘the market’ and a true snapshot of an entire share market, including illiquid and other undesirable stocks, isn’t necessarily the most useful ‘benchmark’ anyway, because you couldn’t practically invest in it.
We just need to be sure, that whatever set of rules make up our Index of choice, we are properly aware of what it is and what it isn’t before we ‘passively’ follow it with our hard-earned money.