Swedroe: New ‘Passive’ Criticism Fails

September 13, 2017

The decades-long trend toward passive investing has led to some very strange comments coming from active fund managers. Some good examples of this can be found in an August 2017 Private Wealth article headlined “Hedge Funds Seen Gaining Market Influence in Passive Boom.”

The author, Lukanyo Mnyanda, writes: “Active fund managers warned Britain’s financial regulator that increased index-tracking is distorting markets by allowing hedge funds with ‘short-term’ outlooks to set prices that don’t reflect fundamentals.” The article contains these interesting statements:

  • An effect on pricing is another consequence of the growth in passive management, which hedge fund manager Paul Singer said is “in danger of devouring capitalism.”
  • Patrick Schotanus, an Edinburgh-based global investment strategist at Kames Capital, which manages about $59 billion from the U.K., offered this: “As more and more people sign up to passive, will there be enough true price discovery?” With fewer firms participating in that endeavor, there’s “the risk that inefficiencies creep into the market,” he said.
  • Alistair Haig, a finance professor at Edinburgh University and who has worked at Scottish investment firms Baillie Gifford & Co. and Kames, asserts that hedge funds are “looking at trading situations where they can make money today, or this week, this month.” He added: “That’s not great for the market because prices may be determined by short-term views.”
  • Active managers participating in a recent study of the U.K.’s $9 trillion asset management industry told British regulators that passive investing’s popularity risks allocating capital to larger companies at the expense of smaller ones less represented in indexes. They also said that hedge funds’ involvement in setting prices is “leading to larger divergences between prices and long-term values.”

Opposing Evidence

These critiques of passive investing are interesting because, if they were valid, we should be observing more and more evidence that hedge funds and active managers are outperforming as prices stray from fundamental values and hedge funds make money on short-term trading. Yet the evidence shows exactly the opposite is true.

For example, the midyear 2017 S&P Dow Jones Indices Versus Active (SPIVA) scorecard found no evidence in any equity asset class that persistence of performance among active managers was greater than would be randomly expected. Making matters worse is that there was a stronger likelihood of the best-performing funds becoming the worst-performing funds than vice versa.

And for hedge funds, the data is even worse. For the 10 years ending 2016, the HFRX Global Hedge Fund Index actually produced a negative return of 0.6%, underperforming every major equity asset class by wide margins, as well as underperforming every bond asset class, including virtually riskless one-year Treasuries. Where exactly is the evidence of hedge funds moving prices to exploit short-term trading opportunities?

Smaller Firms Overlooked?

Let’s turn to the argument that passive investing risks allocating capital to larger companies at the expense of smaller firms that are less represented in indexes.

I assume they are unaware of the hundreds of billions of dollars committed to investments in passively managed small-cap funds. For example, the iShares Russell 2000 ETF (IWM) alone has about $37 billion in assets and the iShares Core S&P Small Cap ETF (IJR) has about $30 billion. The combined assets of the Vanguard Small Cap Index Fund (NAESX) and the  Vanguard Small-Cap ETF (VB) have almost $100 billion.

Even if this argument were true, if less money were being allocated to small companies, we should see evidence of active managers outperforming as inefficiencies arise. Yet there’s no evidence of that, as the SPIVA reports show.


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