Traditionally, any fund seeking to track an index was labelled ‘passive’, while any fund looking to beat an index was labelled ‘active’. Today’s indices have become so narrow and sophisticated that this definition is no longer fit for purpose.
It is, however, understandable in its historical context. The foundations for passive investing can – arguably – be traced back to a couple of young and ambitious financial journalists, much like those covering the industry for ETF Stream today.
In 1882, Charles Dow and his business partner Edward Davis Jones established their eponymous financial news bureau called Dow, Jones & Company. A year later, in November 1883, the firm began to circulate the Customer’s Afternoon Letter – a two-page summary of the day’s financial news.
Included in the letter was the ‘Dow Jones stock average’ – an 11-strong stock index designed to give investors an indication of how the market was performing. Stock market indices were born.
Their growth was steady, if unspectacular. It was not until a decade later, in 1896, that the iconic price-weighted Dow Jones Industrial Average was first calculated.
In 1923, Standard & Poor’s created the S&P 90, a cap-weighted index of 90 stocks. And in 1935 the equal-weight FT 30 was devised, 50 years before it was replaced by the FTSE 100.
It was not until the 1970s, however, that anyone thought to try and replicate their performance. The first index fund was established in 1971 by William Fouse and John McQouwn of Wells Fargo. Their concept was used in 1976 by Jack Bogle’s Vanguard – now a $9.3trn passive investing powerhouse.
At this time, of course, equity indices only covered the broad market. All passive funds were therefore quite vanilla. Active funds, meanwhile, employed discretionary stock picking to try and beat these indices and, perhaps more importantly, their peers.
The distinction between active and passive was therefore clear and uncontentious.
In the 1980s, however, indices with more specific focuses like the Russell 2000 began to emerge. Fast forward forty years and many of today’s indices are highly customised, extremely sophisticated and very narrow in focus.
Indeed, ETF Stream recently wrote about a ‘passive’ ETF from Goldman Sachs Asset Management (GSAM) that tries to generate additional return by targeting the steepest part of the UK gilt curve – in much the same way an active manager would. Because it is achieved within the underlying index in a rules-based fashion, the ETF is categorised as passive.
Another article also questioned how different low tracking error, research-enhanced ‘active’ ETFs were from smart beta ETFs, generally considered ‘passive’.
Research-enhanced ETFs are active in the sense that they attempt to beat a conventional benchmark with the use of IP unavailable to anyone else, but their returns will bear much closer resemblance to a conventional benchmark than any ‘passive’ product tracking a wacky index. Of course, that IP could instead be used to construct an index then trackable by a 'passive' ETF.
In short, the lines have become so blurry that they are no longer fit for purpose. It is time for them to be redrawn.
But where?
On balance, the most compelling classification of ‘active’ versus ‘passive’ comes from a team at State Street Global Advisors (SSGA).
In a recent paper, they wrote that only “the theoretical market portfolio is ‘purely’ passive and in practice only index portfolios that track broad market cap weighted indices - ‘passive-adjacent’ - can be viewed as passive investing. Everything else is active.”
This makes sense. If investors are looking to access the returns of the broad market, then any ETFs used as a proxy should be considered ‘passive’. Every other ETF should be re-labelled as ‘active’.
In the US, for example, ETFs which mimic the S&P 500 and the MSCI USA index can be considered ‘passive’. These indices account for 80% and 85% of the value of the entire US stock market respectively, according to figures from each provider. They are widely used as investable alternatives to the total market.
Indices with different methodologies or narrower universes, however, should be considered ‘active’ given their investors are seeking a return profile other than that of the broad market.
Not everyone agrees. On one end, some have questioned whether broad cap-weighted indices are truly ‘passive’ vehicles.
Speaking at a recent ETF Stream event, Paul Dennis, investment director at Holden and Partners, said: “I have never been a fan of the active versus passive debate. The second you move out of cash you have made an ‘active’ decision to invest.”
The exposures in cap-weighted indices can also be highly concentrated. Is it right that ‘passive’ returns largely hinge on the fortunes of a small handful of stocks?
At the other end of the spectrum, some argue that only ETFs with a high active share and concentrated portfolio are truly ‘active’, of which there are still very few in Europe.
Active share could, in theory, be used to classify ETFs as active or passive. But versus what index do you measure it against and where do you draw the line?
The data providers – perhaps for legacy reasons, perhaps for simplicity – have stuck to the traditional index-tracking definition of passive. By this marker, active ETFs house about 2% of European ETF assets and command around 8% of flows.
The debate, of course, is philosophical. But classifying ETFs as active or passive is important. Not only do we need to a way to measure flows and assets, but issuers routinely use the terms as part of their marketing strategies.
There is, in truth, no perfect way to classify ETFs as 'passive' or 'active'. We should therefore opt for the least flawed definition.
ETFs doing anything other than track broad cap-weighted indices should be re-labelled as 'active'.
