Passive aggression

What happens if the day comes t hat the entire stock market becomes solely made up of passive investors? No more active trades. No short sales, options, hedges or inventory management. Forget about actively managed mutual funds and financial advisers. Just the silence of robots periodically adjusting index weightings when new firms arrive and old ones disappear.

The lure of sharply reduced investment fees has enticed millions of investors to shift their portfolios to passive investments, such as index funds and exchangetraded funds ( ETFs). The cost is l ow because they don’t pay managers to pick specific securities. Instead, the funds assemble assets to mimic the returns of an index or — in the case of so- called smart beta ETFs — create an index tailored to feature certain properties, such as volatility, size and value. It sounds great. But there are problems with all this passivity. And recent policies have been increasi ngly based on the false underlying hypothesis that active management should be discouraged.

Much of the argument in favour of passive investment is based on the presumed failure of active funds to provide superior pre- tax returns on a consistent basis compared to index funds. Research is costly, so if active funds can’t provide a better return than the market, their return — after fees — will be less than what a low- cost passive fund would return. If research doesn’t improve re- turns, why pay for it?

But passive investment works when market prices convey all the information about a security. There is no better information available than what is already contained in an index, yet, the market price is overly simplistic. While prices provide an important signal about the future, they are subject to “noise,” resulting in informational inefficiency that creates value for active traders. When prices change because of political shocks, (think: Brexit) or revolutionary innovations, investors quickly reallocate their portfolios — proving that the original portfolio prices did not contain all the relevant information after all. Informational limitations are particularly acute at the global level, where information is not spread evenly among investors (which is why most investors have a home- market bias).

In the presence of informational inefficiency, there is value to research and hiring advisers. Various financial strategies work because market information is less than perfect — passive investment can miss out these opportunities.

Indeed, passive investors freeload on active investors in the presence of informational inefficiencies. Through t heir research, active investors will reallocate capital from poorerperforming to better- perf orming assets, t hereby increasing the overall value of an index, making passive investors better off, too.

But it’s obvious that relying only on an index is absurd. ETFs are based on market capitalization, so the bigger the firm, the more weight it gets in a passive portfolio. Size alone doesn’t contain all the information needed for trading: Nortel made up 36 per cent of the TSX in 2000 and went bust a few years later. Meanwhile, funds based on an index will often end up holding many unprofitable firms.

Yet, more and more policy seems to be aimed at discouraging active investing. During the debate over Canada Pension Plan reforms, f or i nstance, advocates argued that investors in actively managed mutual funds earned inferior returns due to high fees and insufficient pre- tax returns. That argument helped make the case for an enlarged CPP as a supposedly better alternative to private investing — forcing Canadians to pay higher payroll taxes to hold supposedly “cost- efficient” government retirement portfolios.

Now, some provincial security regulators are looking to ban trailing commission fees embedded in the returns of actively managed funds on the premise that investors are hurt by the supposed conflict that such incentives create, and can turn to advice-free passive investments instead. While there is a case to be made for fee transparency, when the U. K. ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well- prepared for retirement. After all, financial advice is not just about what assets to hold in a portfolio. Retirement planning, tax strategies and financial management are significant factors in achieving financial independence.

Instead of favouring passive investing over active in- vesting, policy should instead remove barriers that make financial planning costly. Ottawa charges GST on financial-management fees, for instance, which is not consistent with an overall approach of exempting financial services from the sales tax. (It’s true that investors can deduct some advisory fees associated with specific transactions from their income taxes, but fees for general advice are not deductible.)

Fans of ETFs and the companies that market the funds insist that active investing can never beat passive investing, since no human can consistently outperform the market. That isn’t necessarily true. The overwhelming number of studies that test the difference between active and passive funds are deficient in some respects; comparable benchmarks are not easy to choose once adjusting for risk and volatility. Some studies show that active management provides better returns, depending on the time frame. A few studies that have focused on after-tax rather than pretax returns have suggested that active management can provide superior returns by choosing better tax strategies for investors. Recent analyses of emerging markets show that active management provides superior returns due to all those informational inefficiencies mentioned earlier.

The healthiest portfolio, and market, is surely one with a balance of both active and passive investments. But for that to happen, policymakers will need to take a more balanced view themselves towards active management. It is much more valuable than the bad rap it has been getting.