isn't really passive, according to a University of Toronto faculty member.
than being passive in any meaningful sense, index investing simply represents a
form of delegated management," wrote Adriana Robertson, assistant
professor in the University of Toronto law faculty, in a paper, "Passive
in Name Only: Delegated Management and 'Index' Investing," issued in
November. The paper has been accepted for publication by the Yale Journal on
Regulation, published by the Yale Law School, and is likely to be published in
mid-2019, she said.
of being truly passive, tracking an index almost always implies choosing a
managed portfolio," Ms. Robertson wrote. "Not only are these indexes
managed portfolios in the strictly financial sense, by their construction they
imply a substantial amount of delegated decision-making authority."
Robertson arguing that index investing is no different from active management?
"The answer is obvious if you think about it," she said in an
interview. "We have this idea in the back of our minds that indexes are
passive because they're divorced from active management decision-making. But
like active management, indexes are just the result of decisions by
While the paper
doesn't focus on institutional investing, Ms. Robertson said the decisions made
by index providers to determine how the indexes are constructed, "should
be a concern for all investors, including institutional investors."
reviewed more than 900 indexes, including 603 that are used as benchmarks for 3,208
mutual funds, she said.
In the paper,
Ms. Robertson also argued that passive mutual funds and exchange-traded funds
often follow indexes that were created for those funds. "The idea that an
ETF might follow an index that it creates is counterintuitive and, to my
knowledge, is not something that has been previously documented," Ms.
Robertson wrote. However, the paper does not detail the impact of index
creation for ETFs on expense ratios, although "digging deeper into this
phenomenon is something that I intend to pursue in further work," Ms.
The data on
fees comes from the CRSP Survivor-Bias-Free US Mutual Fund Database. There are
ETFs based on CRSP indexes.
As a general
matter, some indexes are created to be tracked by certain funds, Ms. Robertson
said in the interview. "Someone will ask for a custom index to track.
Other indexes, like the S&P 500, are used for lots and lots of things —
mutual funds and ETFs, but also options, futures, other derivatives."
However, the paper's premise extends to broader indexes like the Standard &
Poor's 500 stock index, Ms. Robertson added.
One of the chief
issues in Ms. Robertson's paper is that there's no disclosure on who ultimately
is making the decisions on index composition.
"There's not a
lot of regulation, there's no required disclosure of who the decision-makers
are in index creation and composition, like there would be with decision-makers
in a publicly traded company," Ms. Robertson said. "It looks like there
are a lot of index funds out there that are following indexes that are not
nearly as prominent as the S&P 500. These funds sometimes disclose that a
third party created the index with the input of fund managers. But you can't
see who actually is deciding what the index will be composed of."
thinks that lack of information is "something I think people should be
aware of. One way to think about it: If I buy an active mutual fund, the fund
manager makes the decisions (on investments). But whoever is making the index
is making the decisions on what's in them. The only difference between them is
who is making the decision."
Robertson doesn't think the solution is to require index providers to disclose
how benchmarks are created. "I don't think we want regulators directly
regulating indexes," she said. "There are so many indexes that are
used for so many different things. I don't think we want to regulate that whole
area on account of one particular use case — mutual funds and ETFs. I think we
just need to be aware that you need to know how indexes are composed and who is
composing them. As I discuss in the paper, I think that the most appropriate
means of regulation is via the regulation of the funds that use the indexes,
not the indexes themselves."
senior vice president and chief market strategist at Natixis Investment
Managers, Boston, and chairman of the research task force on the Investment
Advisers Association's Active Managers Council, agreed with the paper's
premise, saying that thinking of index funds as purely passive is a
tend to see the differences between active and passive as very black and
white," Mr. Lafferty said. "Their intuition is that when you buy a
passive fund, you're buying the market. However, this misses a key point that
passive strategies are derived from indexes, and the creation of those indexes
is a very active process. Investors are not simply buying the market, they are
effectively buying how the index provider defines that particular market."
Mr. Lafferty said, include "which securities to include, how they are
removed, and how frequently the index is rebalanced. The active decision about
which securities to include can be further broken down into decisions on size, liquidity,
quality or myriad other factors. These active construction rules can have an
enormous impact on the return profile of a passive strategy, especially those
that are focused on more niche areas, like smart beta or factor-based
Agather, Seattle-based managing director of North American research at index
provider FTSE Russell, said it's important to keep in mind the ultimate goal of
categorize many of the decisions we make as active, and note that many of the
indexes being created nowadays are more active in the sense that they differ
from a broad cap-weighted benchmark," Mr. Agather said. "But it is
important to note that the objective of these decisions is quite distinct from
a traditional active strategy in that the goal of the index is to provide
exposure to a particular market segment, whereas in a traditional active
strategy the objective is to determine relative value of individual securities
or market segments. The goal of the index is representation, not
Also, ETFs have
"full transparency available to anyone through the methodologies in
regards to their holdings," said Darek Wojnar, executive vice president
and head of funds and managed accounts at Northern Trust Asset Management,
Chicago. "Some index providers have their own policies for disclosures,
but ETFs disclose holdings on a daily basis," Mr. Wojnar said. "You
could take a look at any ticker any day and find out the holdings. That's not
always the case with active portfolios, which may provide that information
weekly or quarterly."
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