“An Index Isn’t a Fiduciary” and What That Means for Active Management

Abstract

Before the arrival of passive investment vehicles, the role of an active manager was to provide an investor with access to a particular market and, critically, to do so in a way that was aligned with the investor’s objectives. With the rise of passive management, the role of active management was narrowed to “beating a cap-weighted benchmark,” but this shift often took the investor’s goals out of the equation. I believe investors deciding between active and passive implementation should first consider whether a market-cap-weighted index is sufficiently aligned with their objectives or whether a manager, serving as a fiduciary, can construct a portfolio that—after costs—will be better aligned. I also challenge the zero-sum argument that trying to beat a cap-weighted benchmark after fees is futile. My view—that this argument wrongly assumes that all investors have similar preferences—is borne out by deviations between the asset allocations held by institutional investors and the global market-cap-weighted portfolio. TOPICS: Mutual funds/passive investing/indexing, portfolio construction, global markets, performance measurement Key Findings ▪ In distinguishing between active and passive implementation, investors should first acknowledge that any approach that is not market-cap-weighted and intended to capture the breadth of a given market is inherently active, even if offered in an index form. ▪ Market-cap-weighted indexes offer investors several important advantages, but there are many instances in which they may not be structured to achieve the objectives investors seek to achieve. ▪ There is some logic to the notion that for every investor who outperforms a cap-weighted benchmark, another investor must underperform it. Even those who acknowledge this zero-sum argument, however, can still reasonably choose to deviate from these benchmarks to create a portfolio that is better aligned with their objectives.