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Passive funds tracking an index lose out when its make-up changes

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IS THERE hope for fund managers after all? Conventional “active” managers, who try to pick stocks that will beat the market, have been losing ground to “passive” funds, which simply own all assets in a given sector in proportion to their market value. The main advantage of the latter group is that they charge a lot less.

William Sharpe, a Nobel prizewinning economist, argued in 1991 that the “arithmetic of active management” means that the average fund manager is doomed to underperform. To understand why, assume that there are equal numbers of active and passive managers and, between them, they own all the market. The market returns 10%. How much will the passive managers earn? The answer must be 10%, before costs. The active managers own that bit of the market the passive managers don’t. But that proportion of the market must, thanks to simple arithmetic, also return 10%, before costs. Since the costs of active investors are higher, the average active manager must underperform. These numbers hold true, regardless of the proportion of the market owned by the two groups.

But Lasse Heje Pedersen, in a new paper* in the Financial Analysts Journal, takes issue with Mr Sharpe’s argument. Mr Pedersen, who is an academic and a principal at AQR, a fund-management firm, says that Mr Sharpe’s reasoning only holds true if the composition of the market remains unchanged.

In practice, new companies float on the market; others are relegated from—or promoted to—indices such as the S&P 500; and some firms buy back their own shares. The holdings of those investors that were truly passive (ie, did nothing at all) would cease to resemble the market. Someone who bought all listed American stocks in 1986 and did nothing would by now own less than half the market.

So passive investors have to trade to keep their portfolios in line with the index. That gives active managers the chance to outperform. Shares in new issues tend to rise when they float. If passive investors do not take part in the flotations (because the stocks are not yet in the index), they will miss out on those gains. But suppose they do take part. A popular new issue will be oversubscribed and passive investors will get fewer shares than they desire. They will have to top up their holdings after the flotation when the issue has risen in price. Conversely, passive investors will get their full allocation of shares in unpopular flotations, which will probably fall in price.

These points are valid. But how significant are they? The average annual change in the composition of securities in the S&P 500 index is around 7.6%. On that basis, the annual trading costs for a passive investor might be about a quarter of a percentage point. Even including the index manager’s fee, the total cost is still well below the charges made by most active managers.

When it comes to bond indices, however, the market changes a lot more frequently. That is because, whereas equities are permanent capital, bonds have shorter maturities (and some issuers default). For an investment-grade index, the turnover is 49% a year and for high-yield, or “junk”, securities, it is 93%. So trading costs will be markedly higher.

Another flaw in tracking corporate-bond indices, weighted by market value, is that investors end up with the biggest exposure to the most indebted companies. All this suggests that fund managers might have more scope to beat benchmarks in bond markets than they do in equity markets. Another paper by Mr Pedersen’s colleagues at AQR (“The illusion of active fixed-income diversification”) shows that fixed-income managers did indeed outperform their benchmarks, after fees, over the 20 years from 1997 to 2017.

But there is a catch. AQR finds that the reason active managers outperformed the indices is that their holdings were highly correlated with junk-bond returns. These performed very well over the period as a whole. But they exposed the managers to more risk. Their decision might not have turned out so well.

Indeed, if investors were buying bond funds in order to diversify from equities, then the managers were actually undercutting their strategy. Economic scenarios that are bad for equities (recessions, rising interest rates, falling profits) tend to be bad for junk bonds as well.

It is one thing to discover a theoretical way for active managers to outperform. It is another to identify individual managers who can reliably do so.

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Julio Marchi ©

Publisher / Editor at BS News & Media Services
A free thinker, not labelled as anything, not associated with any party, not part of any group or engaged with any religion... A simple guy tired of the nowadays bullshit who decided to promote more serious debates about what is really happening hoping to bring back intelligence to the superficial and shallow news & headlines that unfortunately took over the existing media scene.
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