“Passive” Investing Free Passes

From “Alpha Wounds: Passive Management Is Not Passive“,

Passive investing gets three massive free passes. First, frequently risk-adjusted returns are calculated relative to the benchmark. This means that because benchmarks are both the numerator and the denominator in such calculations, their risk is always cancelled out. This implies that benchmarks have no risk. Clearly this is bogus. What is needed is a neutral way of evaluating risk to which both the benchmark and the active manager are compared.

Second, benchmark returns are always gross of fees. Yet, if you read through the S&P Dow Jones report I referenced above, you get the sense that there is a large team making these decisions. What is the expense of creating and maintaining these indices? Also, the expense of buying and selling the securities from the benchmark is excluded. Yes, the turnover is low, but for a true apples-to-apples comparison, shouldn’t these be included? As a proxy, many investment industry adjuncts evaluate index funds tracking a particular benchmark in order to estimate these expenses. This is clearly fairer to active managers.

The third and likely largest of the free passes handed to passive investors is the massive momentum effects of their “buy lists.” Indices are effectively “buy” lists. For the larger indices this means that there are huge momentum effects embedded into the strategies. So passive investors benefit considerably from non-fundamental factors when their performance is evaluated. To my knowledge, there is no agreed-upon method for how to back these factors out.

In conclusion, passive investing is not truly passive. It is more like less active management. Looked at in this way, it makes obvious certain innate characteristics of smart investing that “passive” investors take advantage of. Maybe active managers could learn a thing or two from these strategies.

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