The changing of the guard in asset management is complete.
Passive overtook active in 2019: Assets in U.S. index funds and exchange-traded funds surpassed those in actively managed funds.
But don’t shed a tear for active management just yet. There’s still plenty of money in vehicles overseen by security-picking managers. And, for that matter, many of the funds classified as “passive” follow indexes that show signs of a human touch.
Start from the top. The king of all ETFs, the $313 billionSPDR S&P 500 ETF Trust, tracks the S&P 500 index. That’s obviously a passive investment, right?
Check out the index’s methodology, and you might have second thoughts. Sure, there are rules for index composition, but membership is also subject to the “discretion of the Index Committee.”
Committee? Discretion? That doesn’t sound too different than an investment manager that has to operate within a set of mandates. And it contrasts with the methodologies of peer benchmarks. “Most other major indexes have a strict, rules-based approach and structured rebalance schedules,” according to a commentary from Vanguard Group titled “Decoding the poetry of the S&P 500,” published on the asset manager’s website in November.
Think discretion is only applied at the margins? Not so fast. Consider how David Blitzer, former index committee chairman of the S&P Dow Jones Indices, described the decision to keep insurance behemoth American International Group Inc. in the index after its collapse in 2008. If the committee had followed the rules, AIG should have been removed. The U.S. Department of the Treasury owned 90% of the company, and the S&P 500 guidelines state that a company is required to maintain a public float of at least 50%. “In those scary moments, dropping AIG would have sent the markets tumbling yet again,” Blitzerwrote in a blog post titled “Inside the S&P 500: An Active Committee,” published on the S&P’s Indexology blog on Aug. 7, 2014. “Given market conditions and investor fears, the index committee quietly set the 50% float rule aside.”
TheInvesco Aerospace & Defense portfolio ETF tracks the Spade Defense Index. Again, it sounds like a passive fund, but the Spade index doesn’t fly on autopilot.
Scott Sacknoff, president of Maryland-based Spade Indexes LLC, says maintaining an element of discretion comes down to the difference between a benchmark and an index. “A benchmark requires an actual understanding of the sector or theme, while an index is just a collection of random firms,” he says. Spade is in the business of developing benchmarks.
Consider the case ofGeneral Electric Co. GE is among the 100 biggest defense manufacturers by revenue, but its defense revenue accounts for only about 3% of the company’s sales, according to Sacknoff.
Spade excludes GE from its defense index because defense isn’t one of the company’s primary lines of business. “One of our rules is that a company has to be systematically important to the sector and the sector has to be systematically important to the company,” says Sacknoff.
To be sure, the use of discretion is more exception than rule, according to Vanguard. The Russell 3000 Index functions much like the tag line for the Ronco rotisserie oven of 1990s infomercial fame: “Set it and forget it.”
“Inclusion in market-cap weighted indexes such as the Russell 3000 is determined by objective eligibility criteria that are clearly set out in the index methodology documentation. There is no individual discretion applied,” wrote Chris Woods, managing director of governance, risk, and compliance at FTSE Russell. “Whether our clients track our indexes for passive investment products, use them as performance benchmarks or for research purposes—they need clarity and consistency on how these products are maintained.”
None of this is to say there’s a problem with S&P or Spade’s approach to selecting their index members. But when you’re investing in an ETF or mutual fund that tracks an index, don’t automatically assume that you’ve removed human judgment from your investment process. Tracking an index does not a passive fund make.
“You shouldn’t just put companies in an index,” says Sacknoff. “You should understand why they’re there.”
Kochkodin is a senior editor at Bloomberg News in New York.
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