James Downie of MitonOptimal South AfricaEvery time one opens the financial press, one is faced with the debate between “active” investing and “passive” investing and, particularly these days, how investor flows have been flooding out of active investing and into passive.

Active investing is easy to define. It is the style of an investment manager to take active bets away from a particular index, investing more in what he or she believes to be cheap shares and less in expensive shares in an effort, over time, to beat that index net of the active fees charged for being so clever. “Passive”, on the other hand, implies that both the investor and the investment manager are lying back and doing nothing and waiting for something to happen. It couldn’t be further from the truth.

Let’s assume that an investor wants to track the US share market in a so-called “passive” way. How does the investor define the US share market? With a short Google search, one discovers that there are literally dozens of ways of describing the market, each with its own passive way of investing. The investor has heard of the Dow Jones Index, the S&P 500 and the Nasdaq and then Google reveals something called the Wilshire 5000. Surely the market is a single entity with only one way of describing it and measuring it?

The table below shows the total return performances over 1 year, 3 years and 5 years to 27 November 2018 of these well-known indices:

 Dow JonesS&P 500Wilshire 5000Nasdaq
1 Year5.3%3.2%2.7%3.0%
3 Year p.a.13.6%10.2%10.1%13.8%
5 Year p.a.11.2%10.0%9.7%14.8%

The investor is now thoroughly confused as the US share market appears to perform very differently depending on which index one chooses as one’s “passive” vehicle. 1 year returns vary from 2.7% to 5.3%, 3 year returns from 10.1% to 13.8% per annum and 5 year performances from 9.7% to 14.8% per annum.

More Googling reveals that the Nasdaq index is an index of IT and tech shares and so can be explained away as tracking a different basket of shares. However, the other three purport to be representations of the market but the Dow Jones Index tracks an equally-weighted basket of the largest 30 shares on the New York Stock Exchange, the S&P 500 is the index that reflects the largest 500 shares weighted by their price and number of shares in issue (or their market capitalisation) and the Wilshire 5000 the largest 5,000 shares by market capitalisation.

So, the passive investor has to make an active decision about which index to use and there are literally thousands of them that mirror different parts of the market, different numbers of shares, different styles of investing and different sizes of shares to mention a few.

Irritated by the variety of US “passive” indices, the investor decides that it is better just to invest passively in all the shares in the world. To their horror, they discover a multiplicity of these as well but plumps for the better known MSCI All Country World Index and the FTSE All World Index hoping the word “All” in both titles will mean the same thing. The returns of these indices are in the table below:

 MSCI All Country WorldFTSE All World
1 Year-3.5%-2.6%
3 Year p.a.7.2%7.9%
5 Year p.a.5.5%6.2%

Again, the passive investor is forced to make an active decision about which “passive” investment to make.

So, in reality, there is no such thing as passive investing. The correct term is an “index-tracker” and the investor needs to do substantial homework to understand which index should be tracked and the expected returns. The market should forget the term “passive” as index-tracking requires specialist techniques and choosing them requires active choice.

Download: Weekly Comment – James Downie, 291118

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