Passive or Active?
Three types of mutual funds that straddle the line.
Fish or Fowl?
The investment community is currently discussing whether so-called smart beta strategies are active or passive. That discussion continues a longstanding debate about where the line between active and passive funds should be drawn--a debate that is now more than 30 years old.
It began when Dimensional Fund Advisors launched its first fund in 1981. While ostensibly an index provider--DFA was founded by University of Chicago MBAs who had been influenced by recent Nobel Laureate Gene Fama, who had preached to them the gospel of efficient markets--DFA diverged from other index-fund managers by creating its own indexes rather than using existing benchmarks, and in its willingness to let its funds drift from those indexes if that meant saving on trading costs. The latter tactic has served DFA well, as its funds have typically beaten the theoretical results of their underlying indexes.
In recent years, DFA has taken additional liberties in exercising judgment about when to add or remove securities to its funds. For example, if the stock of a midsize company gets whacked, so that the company slides down in market capitalization and qualifies for DFA's small-company index, DFA may opt not to purchase the stock for its small-company funds. As a result, DFA now claims that it lies on the active side of the active/passive ledger.
The smudging of the line continued with the mid-'80s' introduction of "enhanced index" funds, which aimed to match the risk exposure of a standard market index by holding the same stocks as contained by the index and by maintaining the same industry exposure, but to beat the index through superior security selection. For example, an enhanced index fund would have the same overall technology exposure as the S&P 500 but would overweight Digital at the expense of Xerox (XRX). (This was the '80s, after all.)
It sounded like a fine idea. Although investment managers might not be able to predict the behavior of the economy, and thus identify the best-performing market sectors, they presumably could take advantage of their training, experience, and access to in-depth research to understand individual companies better than could a retail investor. Or so it seemed. In practice, while the enhanced-index funds did closely track the market benchmarks, they did not consistently outperform them. As a result, few such funds exist today.
Were enhanced-index funds active or passive? On the one hand, they claimed greater managerial insight than did DFA's funds, and they charged higher management fees--both attributes of active management. On the other hand, they sure acted like indexes. Management would be correct in picking PepsiCo (PEP) rather than Coca-Cola (KO), then would miscalculate in overweighting Texaco at the expense of Gulf, so that the stock decisions mostly canceled each other out. So, the funds ended up behaving very much like their underlying indexes, only slightly trailing on average because of their higher costs.
The final type of smudging came from "portable alpha" funds. Portable alpha funds mimic an investment index by purchasing futures contracts that give them the equivalent of 100% long exposure to that index. In Greek-speak, such funds copy an index's "beta." Because the futures contracts require little collateral, a portable alpha fund is left with a pile of cash after securing its beta exposure. If the fund can invest that cash in some fashion that adds little additional risk, but which outperforms the return available on short Treasuries, then it will have a positive "alpha" (to use Greek-speak again) and will thus beat the unadorned index.
PIMCO pioneered the portable-alpha mutual fund, which makes sense given the company's expertise with fixed-income investing. Effectively, PIMCO's hopes with portable-alpha funds rest on its ability to manage cash.
The results have been in the middle of our three examples. PIMCO has done enough to keep its portable-alpha funds in line with the underlying indexes. (The Institutional shares of PIMCO StocksPLUS (PSTKX) have beaten the S&P 500 by 0.24 percentage points per year over the trailing 10 years, while the A shares have lagged by 0.19 points because of their higher costs.) That is better than enhanced-index funds fared. On the other hand, PIMCO hasn't yet shown that it can outgain indexes as consistently as DFA has done.
Are these three types of funds active or passive? I don't know; I'll address that question in a future column, after I sort through the smart-beta debate and develop an active/passive framework.
In a sense, though, the answer doesn't make that much difference. After 20-plus years, the investment lessons are pretty clear. DFA has made an excellent case for itself, PIMCO has done all right if not brilliantly with its PLUS series, and enhanced-index funds have failed at their task.
Are France's highways truer to the American spirit than those of the USA? With its highways, as with so many other items, France offers high quality. The roads are new and smooth; there are no unsightly, distracting billboards; and there are well-maintained rest stops every 20 kilometers. Those are all great, of course, but they come at a high cost. These are toll roads, and they are expensive. In a recent road trip, I paid EUR 50 in tolls (USD 68) to travel less than 500 kilometers.
That approach, surely, is distinctly un-American. I was forced into a high-cost option without being given the chance to select a cheaper experience. Perhaps I would be willing to endure bumpier roads, put up with ugly billboards, and forgo the frequent rest stops in exchange for the EUR 50 that I forked over. However, I was never given that choice.
Then again ... French highways are user-paid. And what could be more all-American than lower taxes and more user fees? After all, why should I pay federal taxes for an interstate highway system that I rarely use? Shouldn't the regional traveling salesman who puts 100,000 miles per year on his car pay for the interstate highways that he uses to such a great extent, sparing me that tax burden?
Rhetorical questions. As with the line dividing active and passive funds, I am not yet satisfied with my answer.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.