Passive investing has wandered far off the path first cleared by Vanguard founder, John Bogle, in the 1970s.
Investors are now stumbling around in an index jungle increasingly populated by products that bear only a loose resemblance to the simple capitalisation-weighted stock market funds designed by Bogle et al, according to a new CFA Institute paper.
The CFA report says the rise of factor-based (or smart beta) strategies, exchange-traded funds (ETFs) and direct-indexing has instead left a trail of confusion for those investors of a passive persuasion.
“… recent index-based strategies, such as smart beta and direct indexing, are said to combine elements of both active and passive management, leaving ambiguities as to how these strategies should be classified and understood,” the paper says.
Genevieve Hayman and Jordan Doyle, affiliates at the CFA Institute Research and Policy Centre, argue in their paper for a new four-tier passive-to-active fund labelling scale that more accurately places each product on the spectrum.
Under the proposed system, a pure cap-weighted index fund would be rated at the low end (scoring a 1) with a step-up in investment discretion – or more precisely, ‘active share’ – corresponding to higher numbers through to a 4 for full actively managed strategies.
For example, factor-based funds would likely rate a 2 or 3 while direct-indexing could range from 1 to 3. Direct-indexing enables investors to own underlying securities in a benchmark but with discretion to exclude or weight according to personal taste.
The investment approach, based on ‘fractionalised’ share technology, is increasingly popular in the US but has yet to make much of an impact in Australasia.
Regardless, the CFA report says the hordes of ill-defined products now roaming the index wilderness must be tamed.
“Investment professionals need to have a thorough understanding of these products to better cater to investor preferences,” the study says.
“Additionally, the introduction of new index-based products has implications for policymakers, given the need for clear disclosures of investment objectives and key product features in fund documents.
“Inconsistent terminology with respect to index-based products has contributed to the ambiguities surrounding their classification as active or passive investments, making it harder for investors to evaluate funds and compare products.”
Hayman and Doyle also advocate for greater scrutiny of index-providers that to-date have escaped much responsibility for their highly influential benchmark weighting or exclusion decisions.
Even the most common cap-weighted passive benchmarks have certain degrees of freedom as per different index-maker policies.
“Whereas an active mutual fund cannot stray from the fundamental policies stated in its registration statement (aside from a shareholder vote), an index can change its methodologies with no restrictions… This situation results in a flow-through effect, as the index provider’s decisions impact the investor’s portfolio…,” the CFA report says.
“Consequently, index-based investments may face unique risks. Increased communication of the active decisions that take place throughout the entire investment decision-making process, including those made by both fund managers and index providers, will enable investors to better understand the risks inherent in index investing.”