Is there a bubble in passive management?

In the market there is talk about whether there is a bubble in passive management, referring specifically to passive index management.

Faced with this question that some people are asking, I have my doubts:

Are they referring to the fact that this type of management causes a bubble in the financial markets or that the increase in the interest of this type of management is considered a fad?

Let us briefly explain what passive index management consists of and why there has been a growing interest in this type of management for quite some years now.

What is index management?

In very general terms, three types of management can be distinguished:

  • Active management actively seeks short-term investment opportunities in financial markets. It is about selecting assets that are undervalued or those with better future prospects and finding the best moment in the markets for each one of them. Active management through analysis and management seeks to do better than a given market as a whole (“beat the market”). Value Investing falls into this category.
  • Passive management focuses on making a good selection of assets and waiting a certain amount of time to check the results, trying to make as few portfolio movements as possible in order to reduce transaction costs. Strategies such as “buy and hold” and low turnover would fall within this type of management. These investment strategies focus on asset selection in the long-term, regardless of short-term fluctuations in financial markets.
  • Index-linked passive management is a type of passive management that consists of replicating the behaviour of a given market index or asset class.

The type of management, as explained in the article “What is an index fund?”, is attributed to the different perceptions that exist in relation to how financial markets work.

To sum up, we can say that an index fund does not believe that, by selecting the best assets and also analysing the best moment in the market, it compensates the cost involved in this type of management in order to do better than a market as a whole.

An index fund is based on the fact that financial markets are efficient enough  at correctly pricing each asset so that there is no opportunity for in-depth analysis looking for the true value of an asset that is not properly priced.

Does index management cause a bubble in financial markets?

The answer is NO, in the sense that the majority of people ask this question. The inflow into the financial markets is the same, the only thing is that it is channelled into other types of products such as index mutual funds and index ETFs.

Regardless of the type of replication used – physical or synthetic – in the management of an index fund, there must always be a counterpart in the market assuming the opposite position in the transactions carried out.

However, even if index management does not cause a bubble in the financial markets, this type of asset management has an undesirable effect on them. We are referring to the efficiency of the markets. Indexed passive management does not perform any type of individualised analysis of each asset and, therefore, does not intervene in the correct pricing of each asset within the market

Index mutual funds and  index ETFs cause bulk movements in the market or asset class that they seek to track.

When investors invest in these instruments, that money enters the market or asset class that it intends to track and causes a block rise in that market with no differentiation between the different assets that make up the market. The opposite happens when investors, usually due to the economic outlook, disinvest in such instruments.

On the contrary, active management, through its asset selection, improves market efficiency. Interestingly, it causes the opposite of what its management is based on, which is to look for market inefficiencies between the intrinsic value and the market price of an asset.  

It is the balance between all types of management and their contradictions that tend to cause markets to function properly. 

What is true, and there are academic and empirical studies that corroborate this, is that due to the increase in non-rational investment (not based on in-depth analysis of each asset and its economic environment), in which index management would be included, there is a growing structural risk of the absence of co-movements between asset prices and their variable fundamentals. This harms active managers who seek to ensure that the market at some point makes a correct adjustment to the intrinsic value of an asset and its market price.

Is the interest in this type of management considered to be a fad?

Index management with investment mutual funds and especially with Index ETFs has been gaining prominence in the world of asset management for years now.

One reason is the ease with which this type of instrument can be used to achieve a portfolio strategy through Asset Allocation (allocation of the portfolio across the basic asset classes).

This is very useful for institutional investment, for example investments made by insurance companies or pension funds managers to cover and guarantee their comintments.

Robo-advisors also use index funds and ETFs for a similar reason. The models and algorithms of portfolio building and management need to use products with a minimum deviation (“tracking error”) with respect to the asset class they use for their asset allocation startegies. Index mutual funds and Index ETFs fulfil this function since it is an instrument aimed at tracking a market index or an asset category.

Also, there is no doubt about the nominal low management fees of this type of product in comparison to, for example, an active management fund or a discretionary portfolio. In another article we will discuss in more depth the reasons behind index-linked passive management such as ETFs that lead to these low nominal management fees.

The increase in popularity of these types of instruments is due to the publicity in their low commissions, coupled with a debate on whether index management offers better risk-adjusted return ratios than active management: European Morningstar Barometer Active/Passive (Dec 2021) | Morningstar

Is an index fund the best option?

In many cases it is not a question of higher or lower returns, but the product most suited to each investor profile. Just keep in mind that in index management, market falls have exactly the same impact on the fund in terms of size and time. 

Meanwhile, active management includes categories such as absolute return (looking for very moderate returns with a focus on risk reduction in order to meet the demand of investors seeking only to preserve capital) based on flexible asset management strategies.

These are flexible investment funds, which in many cases also seek absolute return. Their main feature is the ability to quickly change strategy according to what is happening in the market at any given moment, thanks to the freedom they have in choosing the assets in which to invest, compared to traditional mutual funds. They are often obliged to respect a series of minimum investment ranges when building their investment portfolio.

Regardless of the attractiveness of index investment instruments, fads are often triggered and investors need to know what an index fund is and the reasons why they think they are more suitable for them. When we listen to an opinion for or against, we have to decide whether there is any bias or interest on the part of the person making the assessment.

Beyond the debate about which type of management offers higher or lower risk-adjusted returns, or is most appropriate for each type of investor, it is indisputable that diversification is the instrument that improves the quality of our investments and, for this reason, investing in different types of management and different asset classes (equities, bonds and commodities), also means diversifying our investments and improving the overall quality of our portfolio.

José Luís Álvarez – CEO HollyMontt

Did you like it? Share with your friends:

Do you have a comment or question?

    This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.

    Follow us:

    © HollyMontt, All rights reserved.