Passive Funds Research Articles

How Much Does Tax Erode Fund Alpha?

We model the tax drag from active funds management by simulating portfolios based on reported monthly holdings of 207 active Australian equity funds between July 2000 and December 2010, and then compare both pre-tax and after-tax fund returns versus those for passive indices modeled under the same assumptions. Tax drag erodes 65% of the 0.74% excess return in Broad Market funds, but only 21% of the 1.80% excess return in Small-Cap funds for Australian superannuation (pension) fund investors. We also find that tax drag varies with investment style; market state, and is most detrimental during bull markets; and fund turnover – although the relation between turnover and after-tax excess return is non-monotonic. For high-income individual investors, tax drag is exacerbated to the extent that active management only generates meaningful after-tax excess return for Small-Cap funds of certain styles. Our study highlights the importance of considering tax when choosing between active and passive funds management, as well as how tax impacts can vary according to the circumstances.

The Role of Proxy Advisors and Large Passive Funds in Shareholder Voting: Lions or Lambs?

Proxy advisory firms and large passive mutual funds have faced criticism both for being too powerful and not exercising diligence in proxy voting. We document that the ``Big 3'' passive fund families, Blackrock, State Street, and Vanguard, are increasingly likely to vote with management, and their support is paramount in approving controversial proposals. Meanwhile, mutual funds overall are increasingly less likely to vote according to ISS recommendations. Moreover, neither ISS nor Glass-Lewis recommendations are predictive of controversial proposals passing, especially post-financial-crisis. Our findings suggest that the Big 3 are increasingly influential in voting, and that ISS appears less influential over time.

Passive Investors and Corporate Social Responsibility: a Risk-Management Perspective

This paper develops a risk-management view of CSR by arguing that CSR provides insurance-like effects in adverse corporate events. Since passive investors have diversified away most idiosyncratic risks, we predict that they demand less CSR as a strategic approach to manage risks. Using the annual Russell 1000/2000 index reconstitution as an instrument for passive investor ownership, we find that firms with higher passive fund ownership exhibit significantly lower CSR engagement. The effects are more pronounced among better-diversified passive investors and firms that are not in CSR-sensitive industries. We further show that passive investors hold back CSR activities through the channel of voice by reducing the number of socially responsible investment (SRI) proposals and they do not negatively screen socially irresponsible “sin” stocks. Overall, the findings shed light on the risk-management function of CSR and provide original evidence that passive investors imprint their preference on firm policy.

Hidden Power of the Big Three? Passive Index Funds, Re-Concentration of Corporate Ownership, and New Financial Risk

Since 2008, a massive shift has occurred from active towards passive investment strategies. This burgeoning passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the ‘Big Three’. This paper is the first to comprehensively map the ownership of the Big Three in the United States. We find that already in 40 percent of all listed U.S. corporations the Big Three together constitute the largest shareholder — and even in 88 percent of the S&P 500 firms. This re-concentration of ownership is unprecedented and unlike the earlier ascent of actively managed mutual funds, such as Fidelity, is likely here to stay. In contrast to active funds, the Big Three hold illiquid and permanent ownership positions, which gives them stronger incentives to actively influence corporations. We find that they indeed utilize coordinated voting strategies but generally vote with management, except at director (re-)elections. Private engagements with management represent an important channel through which the Big Three exert influence. Moreover, BlackRock, Vanguard, and State Street are arguably exerting ‘hidden power’ because company executives are likely to internalize their objectives. Finally, we find indications that this development entails new forms of financial risk, including anticompetitive effects and investor herding.

On the robustness of persistence in mutual fund performance

This paper analyzes persistence in US equity mutual fund performance over the period 1990–2015. We apply commonly used measures of persistence, which we test using a set of simulated passive funds. In the first stage we apply contingency tables and transition matrices in accordance with previous literature. Results show how these methodologies are biased towards finding evidence of persistence too easily. In the second stage, we take a recursive portfolio approach, which assesses the performance of investing by following recommendations based on past performance. Results show the importance of both estimating persistence by distinguishing among fund style groups, and considering the cross-sectional significance of recursive portfolios. In general, our results support evidence of persistence in mutual fund performance, especially for the case of the best mutual funds. However, this evidence does not hold for the most recent subperiod, 2008–2015. Empirical evidence of persistence is conditioned by the sample period, a result that could explain the inconclusive results found in the literature.

Money Doctors or Self-Medication? Equity Portfolio Delegation During Stock Market Crises

The willingness of households to delegate their equity investment decisions, understood here as investing in stock funds as opposed to individual stocks, declines substantially between 2007 and 2011. The typical investor in a representative sample of 40,000 self-directed clients at one of Germany's largest retail banks holds 44% of his equities through active and passive stock funds in 2007; by the end of 2011, the median fraction has dropped to 22%. In part, this decline is driven by stock fund investors selling their positions; investors who hold all of their equities via actively managed funds are particularly susceptible to exiting the market during the 2008 crisis. Other investors, especially new clients, avoid actively managed funds and disproportionately buy domestic blue chip stocks at the height of the crises. The decline in delegation, which can also be detected in the broader German investor population and among U.S. households, is consistent with investors losing trust in money doctors and putting themselves in control of security selection and asset allocation. Self-medication, however, hurts investors' financial health: investors who tilt their equity portfolio towards individual stocks experience returns that are significantly lower and more volatile, on average, than had they simply held on to their more delegated portfolios.

Do Enhanced Index Funds Truly Have Enhanced Performance? Evidence from the Chinese Market

ABSTRACTThe index fund market has grown dramatically in China, particularly for active index funds known as enhanced index funds (EIFs). This article is the first to thoroughly exam the performance of EIFs in the Chinese market. Our analysis shows that EIFs in China perform worse than their benchmarks. We note that EIF managers are good market timers when the market does not move significantly. The underperformance of EIFs is primarily attributed to a fund manager’s stock-picking ability; former managing experience is also a factor. Our results suggest that passive index funds are better choices than active funds for fund investments in the Chinese market.

Active Investing in BRIC Countries

We measure active investment for BRIC markets equity funds by contrasting fund returns with local and global index returns. On average passive funds are assumed to replicate the market and therefore their returns are well explained only by local index. We contrast local managers, with non-local ones, self-declared geo-focused on the local market. With this method, we are able to uncover and measure overconfidence biases where local managers are more tied to local indices then mangers explicitly geo-focused on those indices. Results show meaningful differences among countries and fund clusters.

Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds

Actively managed mutual funds sell the potential to beat the market by picking stocks that are expected to outperform passive benchmarks like the S&P 500. Funds that are marketed as active vary substantially in the degree to which their portfolio holdings actually differ from the holdings of passive index funds. A purportedly active fund with a portfolio that substantially overlaps with the market is known as a closet index fund. Since closet index funds charge considerably higher fees than true index funds but provide a substantially similar portfolio, they tend to be poor investment choices. This article presents empirical evidence on closet index funds, showing that more than 10% of U.S. mutual fund assets are currently invested in closet index funds and that high cost closet index funds substantially underperform their benchmarks. We argue that persistent closet indexing implicates a number of legal issues, including possible liability for fund advisors under the Securities Act and the Investment Company Act. We conclude by discussing potential adjustments to mutual fund disclosures that could help investors identify closet index funds.

The role of sovereign wealth funds as activist or passive fund managers

Sovereign Wealth Funds (SWF) have attracted a lot media attention with recent investments in publicly listed companies. Repeatedly, concerns have been raised, such as the fear of industrial espionage or geopolitical threats. We analyze whether SWF managers acquire stakes in foreign publicly listed firms 1) to play an active role which would support concerns or 2) passively select investments to increase the portfolio diversification, for instance. We find that SWF target firms are more profitable, pay higher dividends and have a higher financial stability than their industry peers. This is in line with SWF managers passively seeking for further portfolio diversification in foreign public equity markets. We cannot find an improvement in operating or market performance after the engagement of SWF. Overall, our results indicate strong evidence that SWF managers primarily act as passive investors instead of pursuing activism strategies like private equity funds.

Passive versus Active Fund Performance: Do Index Funds Have Skill?

We apply methods designed to measure mutual fund skill to a cross-section of traded funds that should not exhibit managerial portfolio selection skill: index funds. Surprisingly, these tests imply index fund skill exists, is persistent, and is in similar proportion as in active funds. We use the distribution of passive fund performance to gauge incremental ability of active managers. Outperformance by top active funds is lower when benchmarked to the index fund distribution and disappears when we account for residual risk. Stochastic dominance tests suggest no risk-averse investor should choose a random active fund over a random index fund.

Ten Stocks are Enough in Asia

This paper looks across 13,000 stocks in Asia excluding Japan over 10 years to determine the optimum number an active manager should hold to reduce unsystematic risk. We randomly select stocks for inclusion in equally weighted portfolios that are held for one year and then are reselected based on the new year’s universe. We find that 10 stocks removed 64% of unsystematic risk and, after this, the marginal impact reduces significantly. An additional 10 stocks will only take this number to 74%, but will drive the active fund’s performance closer to that of a passive fund.

International diversification among Islamic investments: is there any benefit

Purpose – The purpose of this paper is to assess the benefits to investors of international diversification among only Islamic funds. Compared to conventional investors who are not restricted in their choice of funds, Islamic investors are restricted to investing in shari’a-compliant funds, thus giving up some diversification benefits. The possibility of international diversification among only Islamic funds may thus help Islamic investors to invest in accordance to their religious beliefs and still benefit from diversification. Design/methodology/approach – The paper assesses the benefits of diversification by analyzing the extent of co-integration among four regional Islamic funds and by estimating the short-term and long-term structural dynamics of and among these funds. The paper uses an Autoregressive-Distributed Lag (ARDL) approach to testing the long-run relationships among these funds and use variance decomposition and impulse response functions to examine the structural dynamics of the relationship between these funds. These methods can also be used for predictive purposes and represent, in authors opinion, a useful approach that complements the traditional methodology of static covariance matrix to find the efficient frontier at a given moment in time. Findings – The results indicate that international diversification can help reduce risk if Asia Pacific Islamic funds and MENA region Islamic funds are invested contemporaneously and/or Asia Pacific Islamic funds and North America Islamic funds, and/or Europe funds and MENA funds. The paper also finds that investors would benefit from investing in North American funds and MENA funds both in the long run and in the short run. Conversely, the paper finds that Europe funds and North American funds are co-integrated in the long-run precluding the opportunity for substantial diversification benefits from these particular portfolio mixes. Research limitations/implications – The long-run analysis helps passive fund managers and investors in composing their portfolio by providing evidence that some portfolio mixes of different regional Islamic funds lead to better risk return performance than one regional Islamic fund portfolios. The short-run analysis however helps the active fund managers and investors as it suggests that diversifying in the short run and reviewing their portfolio on a regular basis would be beneficial as well. Originality/value – This analysis justifies the promotion of Islamic finance as the negative correlation between several Islamic funds across the regions studied suggests better opportunities of investments via international diversification making Islamic funds more desirable.

An Update on the Performance of Actively Managed Etfs

Actively managed ETFs are a relatively recent introduction to the investing landscape, and understanding their performance against passive funds is becoming increasingly important. Consistent with preliminary studies, I find that active funds are more volatile than their passive counterparts and do not provide an absolute return advantage. Thus, active ETFs are generally not good substitutes for existing passively managed funds. However, in contrast to prior studies, I find that performance metrics based on relative risk (e.g., Information and Treynor ratios) suggest that active funds may be good additions to existing portfolios for their diversification benefits. I also find that these relative benefits are primarily concentrated in the funds with the highest average daily trading volume. <b>TOPICS:</b>Exchange-traded funds and applications, portfolio construction, volatility measures

Measuring Performance of Exchange-Traded Funds

Fund selection is an important issue for investors. This topic has spawned abundant academic literature. Nonetheless, most of the time, these works concern only active management, whereas many investors, such as institutional investors, prefer to invest in index funds. The tools developed in the case of active management are also not suitable for evaluating the performance of these index funds. This explains why information ratios are usually used to compare the performance of passive funds. However, we show that this measure is not pertinent, especially when the tracking error volatility of the index fund is small. The objective of an exchange traded fund (ETF) is precisely to offer an investment vehicle that presents a very low tracking error compared to its benchmark. In this paper, we propose a performance measure based on the value-at-risk framework, which is perfectly adapted to passive management and ETFs. Depending on three parameters (performance difference, tracking error volatility and liquidity spread), this efficiency measure is easy to compute and may help investors in their fund selection process. We provide some examples, and show how liquidity is more of an issue for institutional investors than retail investors.

A hybrid approach for index tracking with practical constraints

Index tracking is a popular way for passive fund management, which aims to reproduce the performance of a market index by investing in a subset of the constituents of the index. The formulation of index tracking with some realistic constraints always leads to an optimization problem that is very hard to solve. In this paper, we propose an approximate formulation to the original optimization problem and analyze the approximation error bound. It is shown that the approximation can be reasonably close to the original problem. We consider both cases where the mean absolute error and mean square error are used as the tracking error measurements. The mean absolute error measurement results in a mixed-integer linear programming problem and can be solved by some standard solvers, such as CPLEX. The mean square error measurement leads to a mixed-integer quadratic programming problem. An efficient hybrid heuristic method is given to solve this problem. We do some numerical experiments by the use of five data sets from OR-Library. The results are promising.

When Opportunity Knocks: Cross-Sectional Return Dispersion and Active Fund Performance

Active opportunity in the market, measured by cross-sectional dispersion in stock returns, significantly influences fund performance. Active strategies have the greatest impact on returns during periods of high dispersion, when alpha produced by the most active funds significantly exceeds that produced in other months. The outperformance of the most relative to the least active funds is also concentrated in months of high dispersion. Deciding when to invest in active funds, therefore, can be as important to generating outperformance as deciding which funds to invest in. Switching between highly active and passive funds based on dispersion produces significant alpha of over 2.7% p.a. after fees. This paper adds a new dimension to understanding how active funds can be used to generate value, by combining identification of which managers have the greatest potential to outperform the market with insight into when the market is most conducive to outperformance.

Asset Management Fees and the Growth of Finance

From 1980 to 2006, the financial services sector of the US economy grew from 4.9 percent to 8.3 percent of GDP. A substantial share of that increase was comprised of increases in the fees paid for asset management. This paper examines the significant increase in asset management fees charged to both individual and institutional investors. One could argue that the increase in fees charged by actively managed funds could prove to be socially useful if it reflected increasing returns for investors from active management or if it was necessary to improve the efficiency of the market for investors who availed themselves of low-cost passive (index) funds. But neither of these arguments can be supported by the data. Actively managed funds of publicly traded securities have consistently underperformed index funds, and the amount of the underperformance is well approximated by the difference in the fees charged by the two types of funds. Moreover, it appears that there was no change in the efficiency of the market from 1980 to 2011. Thus, the increase in fees is likely to represent a deadweight loss for investors. Indeed, perhaps the greatest inefficiency in the stock market is in “the market” for investment advice.

The Sovereign Wealth Fund Discount: Evidence from Public Equity Investments

Using a sample of 1,018 Sovereign Wealth Fund (SWF) equity investments in publicly traded firms and a control sample of 5,975 transactions by private-sector financial institutions over 1980-2012, we find that announcement-period abnormal returns of SWF investments are positive, but lower than those of comparable private-sector investments by approximately 2.67 percentage points. We do not find evidence of long-term stock price performance of SWF investment targets differing from that of private-sector investment targets. We do find, however, significant differences among SWFs which are only partially captured by the short-term market reaction: firms acquired by passive funds tend to underperform over the following three years, while positive abnormal returns are associated with actively monitoring SWFs. We conclude that SWFs’ corporate governance role tends to affect the value of the firm.

A Stochastic Portfolio Perspective on Utilizing Active and Passive Fund Management

The proliferation of liquid, transparent, and inexpensive index-based implementation means that investors of nearly all types of investors, individual and institutional, face a persistent implementation question: how much passive and how much active?Placing active fund management in the same framework of uncertainty that asset allocators utilize for other portfolio decisions provides a surprising and enlightening answer to the active vs. passive debate that does not match typical discourse on the matter. Instead of a binary “all or none” answer, reasonable (and even optimistic or pessimistic) expectations for active management imply a balanced implementation approach. Only extreme assumptions (e.g. very positive or negative levels of active return, very short or long time horizons) indicate a binary choice.