Why Index Investing Isn't Passive Investing

by: Felix Salmon posted on: April 24, 2008 | about stocks: EFA / VFH / VTI / VV    

In the debate over active vs passive investing, the base-case assumption is that a passive investment involves tracking a stock-market index, normally the S&P 500. But of course stock-market indices are actively managed, with listing requirements and changing components and survivorship bias and that kind of thing. And according to a fascinating paper by Angelo Ranaldo and Rainer Häberle, actively-managed indices significantly outperform a genuinely passive buy-and-hold strategy.

More precisely, actively-managed indices outperform a passive buy-and-hold approach in up markets, and they underperform in down markets. But since the whole point of investing in stocks is that they tend to go up over long periods of time, one can conclude that there is a real outperformance here over the long term.

I'm not sure how the efficient markets hypothesis deals with this: As you can see from the table above, the degree of outperformance is large. And I don't think it's a self-fulfilling phenomenon, either, where the very fact of being included in an index causes a stock to outperform: The same phenomenon is seen in relatively unpopular indices which aren't benchmarked.

But this is yet another reason to buy index funds rather than individual stocks. If you buy and hold your stocks like any good long-term investor should, you have to outperform substantially just to keep up with the index, let alone beat it.

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Felix Salmon

Felix Salmon

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This article has 3 comments:

  •  
    fxtrader07
    Apr 25 08:12 AM
    I agree with the dismissal of index-tracking being passive investing. However, that seems to be a pretty strange conclusion (ranaldo and häberle), which i have to look into in more detail. Because what I have come across so far suggests the EXACT opposite: Indexes these days are way too actively managed - and poorly so.
  •  
    Gajah
    Jun 19 11:37 AM
    To answer your point about the efficient market hypothesis: it assumes that all available information is included in the share price. I think the amount of information available about a company, even to the people running it is very limited. Therefore investors often buy stocks based on information that is not relevant, giving them false confidence. Hence the dismal performance of actively managed funds.

    Somewhere there is a balance between knowing nothing and thinking you know everything there is to know. I suppose the reason the 'exclusive/selective' indexes outperform the 'real benchmarks' in the long-term is that they are based on information with an optimal level of detail: you know big companies will tend to stick around. For the rest, you don't know, right? Did you see the credit crunch coming? Most bank executives sure as hell didn't!

    As for underperformance during a bear market and outperformance during a bull market: I think most stock trading is speculative. Probably 80% of a company's shares will remain untraded for a year, whereas 20% of the shares are traded perhaps 10 times, explaining a share turnover of 200% per year. Essentially, only 20% of a company's share capital may be 'in play', thus setting the price.

    Because companies in an 'exclusive/selective' index are very liquid (and the index itself is traded too), they are ideal for speculating and therefore more suceptible to market sentiments, making the troughs deeper and the peaks higher.

    Those are my thoughts as a happy and relatively ignorant owner of 'exclusive/selective' index funds.
  •  
    beanluc
    Aug 13 04:21 PM
    Just because the index is actively managed does not mean the TRACKING FUND is managed any more actively than is necessary to maintain the index composition. That' is indeed the very definition of PASSIVE investment management. Indexes are not investments, so an actively-managed index is not an actively-managed investment. To maintain the proper perspectives of apples vs. oranges, you have to compare passive investment management with active INVESTMENT MANAGEMENT, not active INDEX MANAGEMENT.

    The reason that "actively-managed indices significantly outperform a genuinely passive buy-and-hold strategy", as shown by the researchers, is that buy-and-hold does not ever give you any exposure to the "active management" elements you described: "Listing requirements and changing components and survivorship bias". One way to look at it, from the perspective of passive investors, is that the professional managers of indexes perform these activities at no cost to you so that your index fund managers don't have to - which would indeed cost you and which most certainly would harm performance. Those activities do indeed yield results that we all will expect to outperform buying and holding of a never-changing selection of stocks, many of which over time will change to stocks which we never would have selected in the first place, much less blindly held to the point where "survivorship&quo... failure becomes a negative bias on the portfolio.

    All the paper shows is that "actively-managed indices significantly outperform a genuinely passive buy-and-hold strategy" - IN STOCKS. An investor who is indeed following "a genuinely passive buy-and-hold strategy" in index-tracking funds is NOT the investor who will experience the underperformance described in the study. That investor is one who buys and holds stocks, never developing "listing requirements" (so to speak), never "changing composition" (don't passive investors ever even re-balance?) and fully experiencing "survivorship bias" - to the downside. I mean, who even invests this way?
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