Of late there has been a flow of research and opinion pieces focused on the growth of passive investing in US stocks. It’s of little dispute that this growth has impacted the investment environment, but opinion is divided regarding what those effects are, and whether they’ve been beneficial or harmful.
Rolf Agather, Managing Director of North America Research, FTSE Russell, recently oversaw the research and drafting of a new paper on the topic from the global index provider. For the purposes of this research, passive investment was defined as a subset of a larger group of investments which are identified as “index investing.”
The following interview covers Agather’s views on the report’s findings and on the path ahead for passive investing.
What drove this study? Was it prompted by theories that seemed to be gaining credibility despite a lack of supporting evidence?
This paper was largely in response to a number of media articles suggesting that the dramatic increase in passive investing was ultimately bad for investors. One article suggested that passive investing was worse than Marxism for allocating capital. We do not believe this is the conventional wisdom, but headlines like this do get attention and interest from our clients.
Your study addresses the debate over passive investing and its alleged potential to cause price distortion. Could you summarize the two sides?
The argument in question states that for some level of passive investing there will no longer be sufficient price discovery to keep securities fairly valued – therefore capital will not be allocated effectively. The rebuttal would be that capital will be allocated ineffectively only if the lack of price discovery is a permanent state. That is to say, in a world where it’s recognized that securities are mispriced, no market participant would step in to try and make a profit, which seems highly unlikely.
Your report also looks at comments about corporate governance receiving less investor attention, due to the rise of passive vehicles. What’s your view on that?
Some of the largest passive asset managers, including Vanguard and Blackrock, have taken visible steps to represent shareholder interests, which is a welcome development. It contributes to our sense that the corporate governance question will increasingly be addressed by large passive investors.
Based on the findings this new paper contains, how do you expect the passive vs. active debate to unfold in the near to medium term?
With respect to the arguments about price discovery, the existing research—or lack thereof—probably won’t sway the debate one way or the other. It is more likely that investor experience with active management will have a predominant effect on which way the debate moves. If active management isn’t able to demonstrate a clear value proposition in the face of increased passive investing, the debate will continue to favor passive. If active management manages to overcome some of the criticisms being levied at it, then potentially we will see active management come back into favor.
In an environment where passive investing continues to show performance advantages and where theories about its destabilizing market-wide effects go unproven, what sorts of indexes do you see gaining favor? Would it be large and well-understood vehicles such as an S&P 500 Index or something like a Taiwan Plastics Index—obscure but potentially more dynamic to the upside?
These examples highlight the diverse types of investment strategies that can be implemented using indexes, all the while preserving the same key features of all indexes – transparency and objectivity. At their core, indexes are designed to represent exposure to a particular group of securities in a transparent and objective way. And whether that group represents broad market exposure or a specific segment of a market, indexes should always possess these features.
What role do you see for indexes in the initial stage of setting investment objectives?
At the stage where an investor establishes investment objectives and determines an appropriate asset-allocation policy, indexes are typically used as market proxies for each of the asset classes under consideration, such as equity, fixed income, and so forth. By looking at the historical performance and volatility of indexes for the desired markets, investors can form expectations about the future and use these expectations in their asset allocation.
Once an institutional investor has turned toward indexing, should they expect an underlying index to endure in its original form over a long term, or should fairly frequent adjustments be expected?
Investors should anticipate that from time to time the rules used to construct an index may need to be modified. As markets change and new techniques for improving the investor experience are developed, index providers need to adapt their methodologies to ensure that they continue to capture the market exposure originally intended.
Can this be taken too far?
Frequent changes to index methodologies could be a red flag. If the rules governing an index’s construction are being changed frequently it may be a sign that an intended objective isn’t achievable with a purely rules-based index, or that the original rules aren’t successful at achieving the desired objective.
What should investors look for when selecting an index provider?
Look first for high standards of index governance, operational capacity, and construction quality. Good governance ensures that index policies and decisions are made in a thoughtful and disciplined manner and are transparent to the marketplace. An index provider also needs sufficient operational capacity to calculate thousands of indexes daily, plus a high degree of quality assurance since investment products with real investor assets are based on them. The index methodologies should be designed to provide a fair representation of the desired market exposure, and should be constructed to serve client needs, such as investability and low turnover.
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