Passive Investors Aren't That Passive

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Investors have been gravitating toward passive products, but are they tracking the market's performance? I recently sat down with Vanguard's senior investment analyst, Jim Rowley, to discuss some research on that topic.

Jim, thank you so much for being here.

Jim Rowley: It's my pleasure, thank you.

Benz: You had a blog post where you looked at whether investors who are buying passive products are actually tracking the U.S. market. Let's take a step back and talk about the data set that you examined and what you were trying to look at with that research.

Rowley: We started out by thinking about buzz words or claims that you might hear about what passive investors are doing and whether or not they are tracking the market. And we thought well, let's take a look at the data set and find all index funds and ETFs that are labeled as index funds, that have a mandate of tracking some part of the U.S. equities market, whether it's the broad market, nine boxes--it has to have the U.S. equities mandate. And we said if truly all passive fund investors were passive, their relative performance should track the total U.S. stock market. We did that in dollar-weighted terms, and we plotted a rolling 60-month performance. As the chart shows you get a very cyclical experience in terms of, there are periods where those index fund investors outperform the market, and then it shifts, and they underperform the market. It has a very active feeling to it when you see that cyclicality.

In contrast, in the chart we also plot the performance of Vanguard Total Stock Market Index, because if index fund investors were truly passive, they would track the broad market. Again in that chart you can see that the relative performance of Total Stock Market Index Fund is a flat horizontal line that's just a smidgen below zero, meaning it's expenses. That was a bit of a contrast to say if investors were truly in aggregate passive, they would have performance that tracks the market, but they are taking index pieces and they are putting together and building active portfolios.

Benz: Your basic takeaway is not everyone is just buying total U.S. stock market index funds or ETFs and calling it a day and sitting tight with them. They are actually buying different sorts of products and those cause some of the divergences. Does investor timing play a role here as well? Are investors mistiming their purchases of some of their products or do you think it's some of the product choices that are more impactful here?

Rowley: What I think the magnitude of importance is in reverse, I would say I think timing probably is playing a role in there. If I went a next level up and said product choices, some might say product choice meaning an index fund, and it depends upon the index that it's tracking. I would view product choice as non-market-cap-weighted index funds and market cap weighted index funds. Nowadays when we see that label index fund, it includes traditional, plain-vanilla market-cap-weighted index funds, but it also includes the non-market-cap-weighted funds, whether we want to call them smart beta or factor. Those strategies or the indexes themselves have inherent active bent even though their technically an index fund, and that of course leads to a non-total market tracking experience.

I still think the biggest factor here is, and maybe where this disconnect happens, is losing sight between buying passive products and asset allocation. I think what that chart demonstrates is when investors take what are otherwise passive funds and they put them together in portfolios, it just shows the magnitude, the influence, and the importance that allocation decisions have on a portfolio much greater than sort of the product choice that goes with it.

Benz: Does the proliferation of factor products, we've seen a lot of factor-based ETFs crop up, does that have the potential to introduce an even bigger discrepancy between investors tracking total U.S. market performance?

Rowley: It may or it may not, and I think if I tie that back to we should still be starting at the asset allocation decision. I could use a very extreme example here to paint a picture: You could have an investor who says--Investor A, let's call him or her--I am going to allocate to U.S. equities and I am going to pick one passive fund, a small-cap value index fund. And I know that's extreme, but let's say there is an investor that you would say, that's a fully plain-vanilla market-cap index fund. That's a highly active position versus the market. Let's say Investor B has a portfolio made up of factor funds, smart beta funds, and there is a handful of them. Maybe they have a reasonable diversification to the broad market even though it might come with certain tilts maybe to value or small.

I bet the latter, Investor B's experience, will be much closer to the broad market actually than Investor A, that I say just has a concentrated position in small-cap value traditional market-cap-weighted index. To tie that back is just to say the product selection is still a secondary in importance in terms of what the overall asset allocation looks like.

Benz: How about advisors' role in all of this? We've seen more and more investors using some type of financial advisor. Advisors are guiding some of this decision-making about product choices and certainly asset allocation. Do you think that some accountability is lost a little bit, advisors are making these choices, but they are not necessarily accountable directly for some of the choices they are making in terms of product choices?

Rowley: We can think about accountability both from, maybe the client and the advisor perspective. One of the biggest value adds that advisors can bring to their clients is setting an appropriate asset allocation. We'd also like to think that that value add comes with using broadly diversified and low-cost funds, and clearly index funds have been able to have tools come to a portfolio with diversification and low cost. Even when we think about that chart and if we think maybe there is a bit of an active experience, in many cases advisors have sat down with their clients and they have agreed upon their asset allocation or they have agreed upon that investment strategy. Even with that, that doesn't even include maybe some of the products that might be more traditionally active in nature that are added to the mix. When we think about accountability and even if we see things that might look like active portfolios, advisors are likely sitting down with their clients and they are agreeing upon what that strategy is, what's best for the client going forward.

Benz: Jim, really interesting research. Thank you so much for being here to discuss it with us.

Rowley: My pleasure. Thank you very much.