Why passive investing isn’t as passive as you may think

Passive investing has become popular due to low costs and high diversification. But it often means owning poor performers that an active manager can avoid, says Pendal’s SAMIR MEHTA

• Passive investing can add risk to portfolios
• Index providers make active investment decisions
• Find out about Samir Mehta’s Pendal Asian Share Fund

INVESTORS are not paying enough attention to the hidden risks of passive index investing, says Pendal’s Samir Mehta.

Passively investing in funds designed to track the performance of a benchmark has become a popular strategy in recent years due to low costs and the promise of reduced risk due to diversification.

But many investors fail to appreciate the very process of selecting securities for the index is an active investment process that carries with it a level of risk, says Mehta, who manages Pendal Asian Share Fund.

Tracking an index often means owning poorly performing stocks that an active manager can avoid, he says.

“Of course, I’m biased as an active manager of equities.

“But what investors should think about is this presumption that passive investment is really passive.”

Understand the passive process

Investors need to better understand the process for creating the underlying indexes that passive investing relies on,” Mehta says.

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Pendal Asian Share Fund

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Index providers make active decisions on which companies to include, the weighting each company receives and the timing of companies entering and leaving.

These decisions directly affect the buying and selling of stocks by passive investment funds.

“There is a group of people deciding which stock goes into which index, in what proportion — and there is a timing element to it as well.

“People may not think about this aspect of index construction.”

It is not a trivial concern, says Mehta.

Examples: Tesla and Adani

Two high profile examples of the perils of passive index investing are electric vehicle pioneer Tesla and India’s controversial Adani group of companies.

Tesla was added to the S&P 500 index in December 2020 after a ten-fold rise in the company’s share price.

Many investors in index funds passively bought the shares at that high point and are now down on their investments.

At the Adani group of companies, a recent short-seller report made accusations that led to a dramatic fall in share prices across the Adani companies, leading the index providers to reduce the weights of all Adani stocks in the index.

“Passive owners will now be forced to sell those stocks. Buy high, sell low,” says Mehta.

The active advantage

Active managers can often avoid these kind of investing mistakes, says Mehta.

“Active managers contribute not only by identifying good businesses, but also by taking a view on what not to own.

“If we are in a world where future returns are going to be subpar, risk management becomes paramount.

“If you look at the list of top shareholders of the Adani group of companies in India, there is not a single domestic mutual fund that is in the top 25 holders.

“What does that tell you? That none of these smart, sophisticated investors wanted to own this company despite it being a large business with a very high profile.

“But when the index providers put it in the index, passive owners had to own it.”

And it’s not just the index creators making active decisions about passive portfolios — investors themselves can also distort the process.

“If you are taking a decision to make a passive investment in US stocks, you are making an active decision not to invest in Asian stocks,” he says.

“Even if you take a decision to passively invest across all markets, there are still active decisions embedded in that choice.

About Samir Mehta and Pendal Asian Share Fund

Samir manages Pendal Asian Share Fund, an actively managed portfolio of Asian shares excluding Japan and Australia. Samir is a senior fund manager at UK-based J O Hambro, which is part of Pendal Group.

Pendal Asian Share Fund aims to provide a return (before fees, costs and taxes) that exceeds the MSCI AC Asia ex Japan (Standard) Index (Net Dividends) in AUD over the medium-to-long term.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

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