Limitations of Passive Index Investing

The short comings of investing into market index benchmarks are not widely discussed, nor understood.

Market indices suffer from two key short comings:

  1. They have exposures to unrewarded risks, they are therefore suboptimal e.g. think concentration risk, the best example of which is the Finnish Market Index which at one point Nokia made up over 50% of the Index. In New Zealand Telecom once made up over 30% of the Market Index.
  1. Poor Diversification of rewarding risk exposures e.g. they are not efficient. See discussion below.

 

The first short coming is well understood and often highlighted.  This is an issue with the current US market with the growing dominance of the Technology stocks which now make up 25% of the market.  Apple currently makes up around 4% of the S&P 500, this compares to IBM’s 7% weighting in the late 1970s.  Transport stocks dominated the S&P 500 for over 60 years in the mid-1880s to early 1900s.  Therefore unrewarded risks, such as concentration risks, have been a common feature of market indices and benchmarks.

 

The second short coming is less well understood.  In effect, market indices are poorly allocated to known risk premia from which excess returns can be generated from.

For example, and to the point, given their construction market indices are underweight the value and size premia.  These are known systematics risks for which investors are rewarded e.g. the value and size premia

 

Of course we are talking about the rise of Factor Investing, which I covered in an earlier post.

 

We are also not talking about a “factor zoo”, there are a number of limited rewarding risk premia, which are likely to include the likes of value and size (small cap), momentum, and low volatility.  Profitability, quality, and carry are potentially others to consider as well.  Implementation of Factor strategies is key.

 

Fama and French, the fathers of Finance, developed the 3 Factor model in the 1990s.  The 3 factor model includes market risk, value, and size.  It has now become a 5 factor model.  Their pioneering work forms the basis of a very successful global Funds Management business.

This stuff is not new, yet large amounts of money flow into the inefficient and sub-optimal market index funds.  Bond indices are more suboptimal than equity market indices.

 

Therefore, factor exposures provide a more efficient exposure for investors.

The go to analogy on understanding Factors comes from Professor Andrew Ang, factors in markets are like nutrients in food:

“Factors are to assets what nutrients are to food. Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It’s the nutrients in the food that matter. And similarly, the factors matter, not the asset labels.”

 

Factor investing is part of a strong movement by institutional investors away from investing into “asset classes” but thinking more about looking through asset class labels and investing into the underlying factors.

 

Many institutional investors understand that true portfolio diversification does not come from investing in many different asset classes but comes from investing in different risk factors.

The objective is to implement a portfolio with exposures to a broad set of different return and risk outcomes.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and momentum.

 

This is part of a wider shift within the global Wealth and Funds Management industry.  The industrial revolution that EDHEC Risk discusses.  There are better ways of doing things, such as Goal Based Investing.

 

Remember, Modern Portfolio Theory (MPT) is over 65 years old, it is hardly modern anymore.  Although the fundamentals of the benefits of diversification remain, greater insights have been gained over the years and more efficient approaches to building robust portfolios have been developed.

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.


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2 thoughts on “Limitations of Passive Index Investing

  1. Pingback: Andrew Ang on Factor Investing | Kiwi Investor Blog

  2. Pingback: Index Funds buy high and sell low……. | Kiwi Investor Blog

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