Passively-managed funds are dangerous, unreliable and the “perfect oxymoron” given that nobody manages the portfolio’s positioning, according to Yves Choueifaty (pictured). 
The president and founder of TOBAM has been vocal about issues surrounding passive investing for a number of years and says the most efficient way to outperform is to maintain the most diversified portfolio possible.
The debate surrounding active and passive investment is ongoing – while some investors believe that active management is needed to avoid value traps and maximise returns, others say that active funds are too expensive and are exposed to human error.
This could arguably be shown through the performance of the IA Global sector average, which has consistently underperformed the MSCI AC World index over one, three, five and 10 years.
Performance of sector vs index over 10ys
Source: FE Analytics
Choueifaty, who runs an ‘anti-benchmark’ strategy, believes the debate between active and passive is null and void given that passives offer nothing to investors and says future debates will instead be about active investing techniques.
“An industry cannot be sustainably run on something that doesn’t make sense and it simply doesn’t make sense to replicate the market cap within the index,” he said.
“At the end of any bubble, whatever is becoming popular will always eventually burst. Saying that asset management should be run passively denies any future for capitalism.”
“Try to imagine capitalism without active management, you can’t. Capitalism needs capital allocation and, if everybody is passive and simply holds the assets, capitalism will simply disappear. We need volatility, we need prices to change and the only people who make the prices change are active managers.”
In the below article, Choueifaty aims to dispel some of the most commonly-cited benefits of buying into passive funds. Choueifaty has some pretty strong views on index-tracking that some might disagree with, so feel free to start a debate in the comments section.
They’re better value for money
The founder of TOBAM says there is only one truly passive portfolio model and that revolves around mirroring market capitalisation indices.
“Passive means you do nothing and the only portfolio managers that do nothing are those that hold the index because they don’t need to trade,” he said.
“As soon as you hold something different from the market capitalised index you will enter into the field of active management. In my mind, the real debate is not active versus passive – the passive managers are the only people on this planet to be paid for doing nothing.”
“They are passive, they claim to be so, and still they want to be paid. Then they claim they’re cheap but you pay peanuts for them but you don’t even get any peanuts in return, so they’re not cheap.”
Choueifaty says that in order for an investor to take calculated risks as opposed to simply gambling, they need to buy into funds that either actively avoid expensive areas of the market and buy into attractively-valued areas or maintain a portfolio that is as diversified away from the index as possible at any given time.
The latter is how he runs his ‘anti-benchmark’ strategy, which he says has led to the portfolio outperforming all but one year since 2008. The firm has created its own diversification metric to avoid any market bias in terms of sector and therefore avoid dangerous market bubbles.
“Passive management in a way is a perfect oxymoron. Passive management is the absence of management, so how can you be a passive manager? When you’re a passive manager it means you’re not a manager because to stay diversified, you need to trade,” he continued.
“When the price draws up you need to lower your exposure because you don’t want the exposure to go up with the price, neither do you want it to fall with a price that is going down.”
“I think the debate between active and passive is the wrong debate because it is a debate between managing and non-managing, asset managers and custodians.”
“The right debate is between being neutral and being biased and the future debate we will have in our industry will be whether to stay neutral and well-exposed to everything and well-diversified, or to implement bias within portfolios due to pricing and insights.”
Passives minimise human error
One commonly cited reason to not to hold actives is that the portfolio’s performance depends on one team, headed up by just one or two managers in most cases.
Not only can this leave active funds vulnerable to human error, according to some investors, but the fund can be thrown into turmoil if the reigning manager were to step down.
However, Choueifaty says the opposite is in fact true and points out that passive funds are actually more susceptible to human error.
“Passive investment is simply a magnifier of human errors because, when a bubble is high, it’s due to human error and it’s due to consensus which is wrong,” he argued.
“Market cap-weighted indices are not well-diversified. If you want to mitigate the mistakes of human error you want to be diversified and the market cap with the benchmark is not diversified.”
“Investors need to understand that being passive doesn’t make a fund neutral. This is the most toxic thought in our industry.”
He warns that the indices that trackers follow are highly concentrated, despite the fact that many investors buying into passives believe them to be well-diversified.
“If you are aware of human mistakes you want to avoid the benchmark because the benchmark is full of mistakes and, when one mistake is enormous, the benchmark will be enormously biased,” Choueifaty said.
“The more you are aware of human errors, the more you need to be away from the benchmark. Think back to the tech boom bubble, the financial bubble, the oil bubble and the resource bubble. The index is a magnifier of those areas instead of being an antidote.”
“The only antidote I know is diversification. You want to be diversified when the index is absolutely not diversified. “
Passives minimise volatility
Advocates of passives often argue that funds are susceptible to greater levels of volatility due to the ability for managers to make contrarian or deep value calls.
On a broader scale though, Choueifaty warns that an increased popularity in passives would actually increase volatility across markets because nobody will be correcting the imbalances.
“Imagine if we were able to assess whether a certain bias was cheap. What would we do? We would buy this cheap bias and we would make it expensive by contributing to it and therefore we will contribute to the efficiency of markets,” he explained.
“If a certain bias is expensive and suddenly people begin buying what is expensive, what was expensive would become even more expensive and the imbalance become greater.”
“Active managers are here to arbitrate what is expensive versus what is cheap and contribute to the reality of prices. If nobody is doing that prices will mean less and less, then you will have bubbles that will last longer before ultimately bursting.”
He says this is why some markets have a reputation for being more efficient than others – while Japan’s asset price bubble between 1986 and 1991 led to almost a decade-long decline in the economy, the US government provided extreme liquidity to market during the height of the credit crisis and adopted ultra-loose monetary policy.
“If you look at the reputations of the Japanese and the US they’re the two extremes and we’ve seen that the bubbles have lasted longer in one of the markets than the other,” Choueifaty continued.
“One is in a way efficient and the bubbles don’t last as long and with the other it’s a question of trend-following and a lack of arbitrage, which makes bubbles increase and last longer before they are much more impactful when they burst. “
“It’s important to have active managers to make pricing efficient and so that the economy prospers. It’s very important to understand that in order for the economy to prosper we need a reality of prices and this is the role of active managers – to make sure markets are still efficient.”
Strongly agree or disagree with Choueifaty’s views? Join the debate below.
