Passive Equity Investing (2024)

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Introduction

This reading provides a broad overview of passive equity investing, including indexselection, portfolio management techniques, and the analysis of investment results.

Although they mean different things, passive equity investing and indexing have becomenearly synonymous in the investment industry. Indexing refers to strategies intendedto replicate the performance of benchmark indexes, such as the S&P 500 Index, theTopix 100, the FTSE 100, and the MSCI All-Country World Index. The main advantagesof indexing include low costs, broad diversification, and tax efficiency. Indexingis the purest form of a more general idea: passive investing. Passive investing refersto any rules-based, transparent, and investable strategy that does not involve identifyingmispriced individual securities. Unlike indexing, however, passive investing can includeinvesting in a changing set of market segments that are selected by the portfoliomanager.

Studies over the years have reported support for passive investing. Renshaw and Feldstein (1960) observe that the returns of professionally managed portfolios trailed the returnson the principal index of that time, the Dow Jones Industrial Average. They also concludethat the index would be a good basis for what they termed an “unmanaged investmentcompany.” French (2008) indicates that the cost of passive investing is lower than the cost of active management.

Further motivation for passive investing comes from studies that examine the returnand risk consequences of stock selection, which involves identifying mispriced securities.This differs from asset allocation, which involves selecting asset class investmentsthat are, themselves, essentially passive indexed-based portfolios. Brinson, Hood, and Beebower (1986) find a dominant role for asset allocation rather than security selection in explainingreturn variability. With passive investing, portfolio managers eschew the idea ofsecurity selection, concluding that the benefits do not justify the costs.

The efficient market hypothesis gave credence to investors’ interest in indexes bytheorizing that stock prices incorporate all relevant information—implying that aftercosts, the majority of active investors could not consistently outperform the market.With this backdrop, investment managers began to offer strategies to replicate thereturns of stock market indexes as early as 1971.

In comparison with passive investing strategies, active management of an investmentportfolio requires a substantial commitment of personnel, technological resources,and time spent on analysis and management that can involve significant costs. Consequently,passive portfolio fees charged to investors are generally much lower than fees chargedby their active managers. This fee differential represents the most significant andenduring advantage of passive management.

Another advantage is that passive managers seeking to track an index can generallyachieve their objective. Passive managers model their clients’ portfolios to the benchmark’sconstituent securities and weights as reported by the index provider, thereby replicatingthe benchmark. The skill of a passive manager is apparent in the ability to trade,report, and explain the performance of a client’s portfolio. Gross-of-fees performanceamong passive managers tends to be similar, so much of the industry views passivemanagers as undifferentiated apart from their scope of offerings and client-servicingcapabilities.

Investors of passively managed funds may seek market return, otherwise known as betaexposure, and do not seek outperformance, known as alpha. A focus on beta is basedon a single-factor model: the capital asset pricing model.

Since the turn of the millennium, passive factor-based strategies, which are basedon more than a single factor, have become more prevalent as investors gain a differentunderstanding of what drives investment returns. These strategies maintain the low-costadvantage of index funds and provide a different expected return stream based on exposureto such factors as style, capitalization, volatility, and quality.

This reading contains the following sections. Section 2 focuses on how to choose apassive benchmark, including weighting considerations. Section 3 looks at how to gainexposure to the desired index, whether through a pooled investment, a derivatives-basedapproach, or a separately managed account. Section 4 describes passive portfolio constructiontechniques. Section 5 discusses how a portfolio manager can control tracking erroragainst the benchmark, including the sources of tracking error. Section 6 introducesmethods a portfolio manager can use to attribute the sources of return in the portfolio,including country returns, currency returns, sector returns, and security returns.This section also describes sources of portfolio risk. A summary of key points concludesthe reading.

The member should be able to:

1. discuss considerations in choosing a benchmark for a passively managed equity portfolio;

2. compare passive factor-based strategies to market-capitalization-weighted indexing;

3. compare different approaches to passive equity investing;

4. compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios;

5. discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios;

6. explain sources of return and risk to a passively managed equity portfolio.