Passive Aggression: Actively Wielding Index Funds

Over the past 20 years, I’ve been involved in a lot of discussions trying to determine the best use-case for either active management or passive investing. This conversation has taken place in institutional client boardrooms, investment committee meetings, and in living rooms with individual investors. In almost every case, the discussion centered around the “passive” concept with proponents focused on lower fees, and detractors focused on the unmanaged and unsupervised nature of the style. These arguments have a lot of nuance and can be equally compelling when reviewing a particular fund. What is important to note, however, is that building a portfolio that incorporates passive investment vehicles requires active fiduciary care and diligence; it is neither unmanaged nor unmonitored.

 What are Passive Investments?

Passive investing has been around since the 1970s, with John Bogle creating in 1975 what would become the Vanguard 500 Index Fund. Passive funds attempt to track the performance of a benchmark index by replicating the basket of assets monitored by the index. For instance, an S&P 500 index fund would seek to own the 500 companies of the S&P 500 at the same allocation as the index. There are many such passive vehicles tracking a variety of indexes in both equity and fixed income markets around the world. In the case of fixed income markets, replicating the index name for name can prove difficult due to the size of the markets, so passive strategies often replicate the characteristics of an index through a representative basket of securities. In all cases, passive investments are meant to look like the index, generating similar returns for similar risk. Unlike actively managed investments, they are not designed to beat their individual benchmark. Active funds rely on the knowledge and skill of a portfolio manager to use a security selection process in determining the best names to use to beat a benchmark index. Passive funds simply aim to “be the benchmark.”

There tend to be two main vehicles for passive investing: mutual fund securities and exchange-traded securities. Exchange-traded securities have become increasingly popular for a variety of reasons, and they are quickly approaching the size of some of the bigger mutual funds. However, Vanguard maintains two of the largest index mutual funds, and they are still three times larger than similar exchange-traded securities. Choosing between these different vehicles comes down to purpose and fit. However, exchange-traded securities are often more tax efficient for owners, resulting in lower capital gains distributions than mutual funds. The biggest technical difference between mutual funds and exchange-traded securities is in how they trade. Mutual funds trade once daily, at the closing price. Exchange-traded securities trade throughout the day.

Using Passive Investments

Passive investments have become an indispensable tool for generating risk-adjusted returns in portfolios. While there is ample room for actively managed funds within any given portfolio, many actively managed funds have struggled to keep up with their respective benchmarks over the last ten years. Active managers have the difficult task of identifying winners and holding them while also avoiding the losers that create drag on performance. Missing a winner or a loser can have dramatic effects on the success of the strategy. Passive funds do not have this element of risk. They will achieve a benchmark-like return. Any underperformance is a structural phenomenon, with fees or expenses causing the issue, not market behavior. However, with passive investments, outperformance of the market is not in the cards. They simply achieve benchmark-like returns, no more, no less.

Passive investments stay closer to the benchmark consistently, always adjusting to look like the index, smoothing returns out over the timeframe and lending a degree of regularity to the returns. It is this consistency in the form of low tracking error to a benchmark that allows a portfolio manager to improve risk-adjusted returns in an overall portfolio. Essentially, a portfolio manager can maximize return per unit of risk by identifying the markets best suited to active or passive investment vehicles.

The important thing to note is that a portfolio manager makes active decisions about when to employ a passive fund as opposed to an active fund. This is the first element of monitoring and actively managing a passive strategy. While the funds employed may be passive, they are not “set it and forget it” types of investments. Rather, there is an ongoing decision-making process that identifies the best time to remain passive and when to employ more active managers. In a particular environment, portfolios could lean more towards indexing, and in another, a tactical choice around active managers might cause shifts in allocation. While the funds in use may be passive, the manner in which they are used is most certainly not!

The second element of monitoring and actively managing a passive portfolio strategy is in the asset allocation across the portfolio. A portfolio might be benchmarked to the S&P 1500, for instance, which has a measurable allocation to large, mid, and small domestic companies. A portfolio manager could choose to construct a portfolio based on these component pieces, choosing a passive fund for large company exposure, another passive fund for mid company exposure, and a third for small company exposure. These funds could be deployed in an exact replica of the S&P 1500 allocation, but it is far more common to see a portfolio manager deploy the funds in a combination of overweight and underweight positions to take advantage of the tactical opportunities in the market. In essence, while the investment vehicles may be passive, the asset allocation is artfully managed. The result is an actively managed passive portfolio.

Greenleaf Trust’s Active Index Strategy

Greenleaf Trust has taken this concept and produced an investment strategy that produces risk-adjusted returns in a tax-advantaged portfolio. It balances the use of highly efficient exchange-traded funds in transparent markets with strategically employed active managers in more opaque markets. The passive vehicles are also deployed with an eye towards tactical opportunities in various market segments, allowing for a fine-tuned actively managed portfolio. Used this way, Greenleaf Trust’s active index strategy is designed to outperform benchmarks through tactical tilts in asset allocation as well as thoughtful inclusion of actively managed funds. It is not a one-size-fits-all strategy, in that some situations allow for less tax efficiency and are more suited to active bets on the market. But for those situations where low cost, tax-efficient portfolios are advisable, an actively managed portfolio of passive investment vehicles may be an ideal solution.