Q&A: Passive Investing

Is passive investing in indexes creating “distortions” that can be exploited by active strategies?

studying a graph

Question: John Levin, CEO of hedge fund Levin Capital Strategies, challenged the passive approach to investing in a letter to the editor of The Wall Street Journal, stating, “The success of passive investing has created unusual opportunity because of the distortions that have developed with money flows into indexes and out of actively managed strategies.”

Further, he states, “I don’t believe the valuation discrepancies caused in part by passive investing are sustainable.” He ends with, “There will be a time when the fork gets stuck in index funds and the bubble bursts.”

Is Mr. Levin describing a possible flaw in your strategy of passive investing? Do you agree or disagree that passive investing in indexes is creating “distortions” that can be exploited by active strategies and is leading to a “bubble”? Do you think there’s merit to his argument?

Ric: I have a couple of comments. First, Mr. Levin runs a hedge fund, so he earns a living as an active manager and is therefore biased. (And if he’s like most hedge fund managers, he charges his clients 2 percent per year plus 20 percent of the profits!).

I am not aware of any data to support his contention that active managers outperform passive investing. In fact, all the data I’ve seen demonstrate just the opposite: Active managers have a horrible track record compared with passively managed funds.

For example, according to the SPIVA Scorecard, 93.39 percent of large-cap stock funds underperformed the S&P 500 stock index for the three-year period ending Dec. 31, 2016. That’s a heckuva failure rate! So it’s hard to understand what the bubble is that he’s talking about, or why it might burst.

Second, he does have a point about index funds, but index funds are not to be confused with passive investing.

Every year, index providers announce changes to their indices. They state the changes they are going to make and when they plan to make them. This gives investors an opportunity to buy or sell securities in advance of the changes.

For example, if a stock ranked #41 is going to drop to #43, funds that mirror the index will sell shares. If a stock is to rise in the ranks, index funds will buy shares. You might try to exploit this news by trading ahead of the index funds.

I describe this in greater detail in my book The Lies About Money. Aside from this nuance, which is debatable regarding investor benefit, I don’t see what his fuss is about. (And if all he’s trying to do as a hedge fund manager is engage in such arbitrage, he’s dramatically overcharging for his services.)