Passive management and index funds

We became very defensive, to say the least, when we received a query on passive management from a reader. This reader, apparently a researcher, argued that index funds cannot be classified as passive management in the context of the four-box active-passive matrix. The question then is: What is passive management?

This article explains why index funds can be argued as non-passive management. It then discusses, using standard portfolio concepts, funds that fall within the true meaning of passive management and shows how investors can create such exposure.

Passive management Vs Indexing

The four-box active-passive matrix separates professional management of fund (security selection decision) from the investor's action to buy-and-hold or actively trade on her investment in the fund (market timing). The active-active approach refers to an individual's continual buying and selling of units in an active fund. At the other extreme is the passive-passive approach where the individual buys and holds an index fund till her investment horizon. In between are active-passive and passive-active approaches.

Now, an index is just a collection of securities based on some criteria. And there are several indices in the market. If an investor chooses to invest in a Nifty Index Fund instead of a Mid-cap Index Fund, she is making an active choice of selecting the Nifty index, so the argument goes.

The strategy would, hence, fall within the passive-active quadrant; buy-and-hold strategy on a portfolio that is actively selected. Our reader's argument appears technically valid. Why?

Recall that index funds are based on the Efficient Market Hypothesis, which essentially states that it is difficult for investors and professional money managers to consistently beat the market.

A related capital market theory states that a truly diversified portfolio is the market portfolio; this refers to all securities available in the market. Index funds provide exposure to only part of the market. And investing in part of the market would, hence, amount to active selection.

How can investors create a portfolio that falls in the passive-passive quadrant in the four-box matrix?

It is not practical to hold a market portfolio for two reasons. One, the investor may not have the capital to buy all the securities. And two, transaction costs for small-cap stocks are prohibitive. There is, however, rationale in holding a market portfolio.

Portfolio theory supported by empirical evidence shows that an individual is systematically rewarded for taking market risk and not for company-specific or non-systematic risk. And an optimal exposure to market risk is through a market portfolio. So, only a passive fund having a market portfolio can fall in the passive-passive quadrant of the four-box matrix.

But asset management funds do not offer such products. An optimal solution is, hence, a passive exposure to asset classes. In the US, investors can get such an exposure through passive asset class funds, which are more diversified than typical index funds.

Investors in India can get market exposure only through broad-cap index such as the S&P CNX 500 Index. Another way would be to buy Nifty Index Fund, CNX Mid-cap Index Fund, Small-Cap Fund and Micro-cap Fund, if and when they become available. Alternatively, investors can ask their private wealth managers to create a market portfolio. As a first step, the private wealth manager should create a universe of all traded securities in the market.

The next step would require application of quantitative models to select fewer securities that would replicate the performance of the market universe. Replication seeks to lower the capital required to create the market portfolio and cut transaction costs on illiquid securities.

A market portfolio that fits the passive-passive quadrant in the four-box matrix is not easy to create. Investors have to either settle for a broad-cap index fund or replicate the market portfolio. The replicating portfolio would strive to capture market risk and earn market return without holding all the securities. Such a portfolio would form part of the passive core. The satellite portfolio would then consist of stocks which investors would trade actively to generate excess returns.

The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com

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