Passive investments are often misunderstood; instead of
providing static positioning, as the label would imply, market
and sector turbulence makes them prone to fluctuation. To tame
a passive asset, we think investors need to exert more active
control over the dynamics of volatility.
Sound confusing? Not really. Think of it this way:
volatility determines much of the risk profile of any asset. So
when market volatility fluctuates, the risk of a passive
investment in the market's index changes.
For example, if you invested $100 in the MSCI world index
earlier this year, when volatility was hovering near 11
percent, you risked losing $11. Yet just more than a year
earlier, when volatility was hovering around 25 percent, the
same $100 in the same index put $25 at risk. With this in mind,
isn't it a misnomer to describe a fund with such variable risk
as a passive investment?
Our colleagues at AllianceBernstein have written extensively
concentration risks of investing in a benchmark. For
example, in 2000, the technology sector ballooned to nearly 30
percent of the S&P 500 index, leaving investors exposed to
excessive risk when the crash occurred. Less attention,
however, is typically paid to the volatility risks of erratic
About the same time that indexes were getting bloated with
technology stocks, the risk of being in that sector shot up
fourfold, accounting for 50 percent of the total risk on the
index. When oil prices flare up amid tensions in the Middle
East, the volatility of the energy sector typically rises as
well. And of course, during the global financial crisis, the
financial sector accounted for more than 30 percent of the
total volatility in the MSCI world index.
In other words, you may have ditched your active manager to
invest in a market-cap-weighted global equity index, but
instead you let the world actively manage your money.
Conventional wisdom that passively managed buy-and-hold
portfolios (such as many market-cap benchmarks) yield passive
investments tells an incomplete story. Passive management of an
investment portfolio in a dynamic world results in active and
Is there a way to create a portfolio that delivers truly
passive risk? We think so. The trick is to take a dynamic
approach that aims to undo the randomness of volatility. An
ideal passive benchmark would flatten the waves into a fixed,
straight line. The flat lines reflect equal passive nonvarying
risk-taking in each sector. So if there are seven sectors in
the benchmark, a flat line at about 15 percent would yield
equal risk for each sector.