Why Passive Investment's Don't Exist
Index funds are popularly known as passive investment vehicles but in actuality, they would be better defined as being relatively low maintenance funds.
I could be wrong, but I believe that index fund providers such as Vanguard, Blackrock and Betashares have utilized the term passive investment for their own nefarious marketing purposes. Maybe nefarious is the wrong word, but it certainly has been a great marketing spiel over the years.
It’s a great story. “We don’t do anything fancy, we just invest in the index and let the market do the work. We keep the costs low, which improves returns and you can leave the expensive analysis and price discovery to the master of the universe but ultimately largely under performing active managers”
When it’s put that way it presents a compelling case to invest in a “passive manner”. However, at the end of the day I believe the term passive is not appropriate for multiple reasons.
The goal of an index fund is to replicate the performance of a basket of stocks, bonds or other assets. To keep it simple, let’s talk consider manner of the ASX200 index funds.
Their goal is for the performance to closely resemble the performance of top 200 companies on the ASX. Now, as we have all experienced over the last few months, companies can move in value at a rapid pace.
As these companies increase or decrease in price the index fund will rebalance their allocations towards these businesses in order to ensure that they maintain their mandated exposure levels. Typically, these underlying indexes are rebalanced on a quarterly basis.
On the most recent rebalance, the increasingly headline grabbing and troubled wealth conglomerate AMP is no longer one of the 50 most valuable businesses in Australia. While the fast growing and increasingly popular A2M milk has joined the ASX50. As a result of these changes, an index fund will sell shares in AMP and buy shares in A2M.
When a company is no longer of enough value to be in a specific index, it will be removed in its entirety and replaced by another business. This strategy continuously provides investors with exposure to businesses that are increasing in value and decreases the exposure to decliners at the same time.
I could define this as many things, including a moment strategy but I can not in good conscience call this a passive way of managing money.
Let’s take a step back again. Purely, the decisions of where to allocate your capital is in actuality an active decision. Even for someone who automates their reinvestment and ongoing investment (or superannuation) contributions is still making an active decision regarding the ultimate capital allocation decision.
Index funds are certainly a great way to achieve broad diversification, strategic exposure while maintaining low ongoing fee’s. What they most certainly are not, is a passive investment.
In my professional opinion, even for an investor that buys a stock with the intention of never selling it will still have to make active strategic decisions.
Do you reinvest the dividends? What about shareholder votes? What about when share buybacks or share issuances are offered? Investing is always an active process.