When Passive Investing Goes Active

May 08, 2020

In the world of passive investing, we are being reminded this year that necessity really is the mother of all invention—and intervention.

Passive ETFs and their underlying indexes are loved for their rules-based constancy, if not altogether predictability. It all comes down to the rules. No guessing games; no timing the markets; no relying on a manager’s expertise to outsmart the market; no losing sleep over unexpected swings in portfolio allocation.  

But in a year like 2020 when a pandemic brought economies around the globe to a screeching halt, pushed unemployment into the tens of millions in the U.S. alone, and redefined what market volatility looks like, passive investing suddenly has needed a little active intervention—or so we’ve seen.

Active Intervention

Consider all the action in the trader- and retail-loved United States Oil Fund LP (USO) this year. It’s only May, but we could go out on a limb and call USO the posterchild of passive rejiggering this year.  

Since 2006 when this futures-based ETF came to market, it has grown to become the go-to strategy for anyone looking to play the oil market as closely to spot oil price performance as possible. Why? Because USO is the only ETF—not leveraged or inverse—that offers access to front-month WTI crude oil futures only. That’s the fund’s benchmark. The entire portfolio is tied to the nearest-to-expiration oil futures contract for a performance that’s as close to trading spot oil as any investor can. (Read: Why You Can’t Buy Spot Oil)

But a pandemic wreaking havoc on an already tenuous supply/demand balance in the oil market changed all that. Massive supplies with nowhere to go pushed oil prices sharply lower, even into negative territory for the first time in April.

As oil prices plummeted, investors rushed to buy USO, looking to enter the market at the bottom, and to tag along on its expected recovery rally. USO has gathered more than $6.5 billion in net new money year-to-date, the bulk of which came in April in one of the biggest exercises we’ve seen in bottom picking.

What happened next has been well discussed and covered. But the gist is this: USO had to adapt. The fund hit position limits dictated by the CFTC, and it also ran out of shares to issue to meet investor demand. In the end, the front-month-only USO had to give up on that methodology for the time being, and invest in other futures contracts in the curve. Today, USO owns oil futures all the way up to the June 2021 contract.

When you go into USCF’s webpage for USO, you are greeted by a big red box alerting you of this change of course (See below):

Source: USCF

Passive Looking Pretty Active

USO isn’t the only example we’ve seen of fund managers or the industry taking measures into their own hands.

S&P Dow Jones Indices, in March, postponed its quarterly rebalancing of several equity indexes—the firm is behind the Dow Jones Industrial Average and the S&P 500—due to turbulent market action. Remember that history-making March selloff?

At the time, the index provider said the decision came out of “thorough consideration of how best to support our clients and govern our indices during this period of extreme global market volatility, market wide circuit breaker events and exchange closures.”

Index rebalancing—which means ETF portfolio rebalancing, too—is one of the ballasts of long-term passive investing. Buy, hold, rebalance. But that, too, can hit a snag when the world is faced with a series of firsts: pandemic, economic shutdown, shelter-in-place, negative oil prices, etc. 

Rebalancing Tightrope

Just this week we’re seeing a trickle effect from that. Invesco was hit with a $105 million reparation for essentially misunderstanding S&P’s rebalancing schedule change, and not rebalancing two of its mutual funds tied to equal-weight S&P 500 benchmarks. Invesco caught the miss, and rebalanced within the week, but the delay resulted in performance disparity between the funds and the markets, and now Invesco is working to make shareholders whole.  

To be clear, there are no nefarious shenanigans here to be exposed. Deviating from the stated course can happen, and it’s often detailed as a possibility in most ETF prospectuses. USO did what it had to do by abandoning its benchmark—and what it could do—to accommodate extenuating, unforeseen circumstances. S&P Dow did what it thought it had to do for its clients. And Invesco, well, got confused, but at this point, can anyone blame them?  

In the end, we are back at where all ETF conversations begin: due diligence. It’s up to the end investor to understand the latitude their passive ETFs—and the indexes underneath them—have to navigate challenging markets.

In a year where nothing has gone according to plan, it’s not too surprising to see that passive investing, too, can hit obstacles, and require some hands-on, quick-on-its-feet active decision-making.  

Contact Cinthia Murphy at [email protected]

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