Why Passive Funds May Underperform
Passive investing is often seen as a low-cost, minimal-effort way to invest. While this is somewhat true, it is not the whole story. There are still risks and costs to address when considering investing in a passive fund.
A passive fund attempts to mirror the performance of its benchmark index by holding the securities of that index in the same weightings as the index. No active investment decisions are made.
One of the greatest risks is the inherent potential for passive funds to underperform their benchmark indices.
Causes for Potential Underperformance
Emphasis on Yesterday’s Winners
Passive funds are constructed to mirror their benchmark indices. Most indices are capitalization weighted (cap-weighted) so the index allocations are typically more than 70% to the larger cap-weighted stocks, which have gained that larger cap-weight mostly due to historical growth.
A passive fund cannot choose to overweight the benchmark index’s smaller capitalization stocks even though they may have the potential for greater future growth.
Passive Funds Can Be Held Back by Holding Cash
Often passive funds are in a position where cash acts as a drag on their returns. This can be a result of receiving dividends from their investments. The delay between receiving the cash from the dividends and reinvesting that cash into shares can result in underperformance. In upward-trending markets, they will almost always trail their benchmark index owing to their cash holdings.
Passive Funds Are Constantly Seeking to Rebalance
Most passive funds will never exactly mirror their benchmark indices. Although they always seek to have the exact security weightings as their benchmark indices, liquidity issues can prohibit them from rebalancing on a timely basis (tracking error).
Rebalancing is largely required due to cash inflows. Accordingly, when investing new cash inflows, passive funds are often forced to buy up-trending securities (opposing the basic investing premise of buy low/sell high). They also may be unable to fully replicate the smaller-capitalization weightings of the indices since given the size of small cap stocks there often is not enough liquidity. This results in passive funds chasing their benchmarks and possibly trailing them.
Passive Funds Still Have Costs
Passive funds may have lower management costs than most actively managed funds, but they still have costs. Most passive fund fee surveys show management expense ratios of 0.40% to 0.70%. This can be interpreted to mean that a perfectly mirrored passive fund would trail its benchmark index by a minimum of its management expense ratio.
Unlike actively managed funds, passive funds are not seeking to outperform their benchmark indices. Therefore, passive funds lack the capability to provide excess returns to compensate investors for management fees.
Passive or Active Management
Increasingly investors are questioning passive funds’ performance relative to their benchmark. When investing, it is important to consider that there is no such thing as a free lunch. So, even with passive investing, you must consider the risk/return tradeoff.
Indeed, the risk/return tradeoff of some actively managed strategies may outweigh the fee savings of using passive funds. In particular, actively managed strategies that emphasize stock picking resulting in a high active share (having significantly different weightings compared to the index) have provided a better risk/return tradeoff than many passive funds.
Active Management with Bloom Investment Counsel
At Bloom, we offer our clients high active share (greater than 80%), actively managed, customized Canadian and U.S. dividend-paying portfolios to help protect, maintain, and grow their wealth.
With a focus on dividend-paying investments, for over 25 years, our clients are able to generate regular income from dividend payments and capital appreciation of the stock price, allowing for a better overall return on investments.
For more information on our active management approach, contact us today. Give us a call at +1-416-861-9941 or email us at info@bloominvestmentcounsel.com
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.