CFA Institute Develops Framework to Clear Up Passive/Active Confusion

The CFA Institute Research and Policy Center, an association of investment professionals, has issued a new investment classification framework aimed at clearing up confusion about passive index-based strategies that often include active involvement.

The framework is intended to provide policy recommendations for regulators and firms concerning transparency, communication and investor comprehension of smart beta, direct indexing and index-based investment products. In a report detailing the framework, the CFA classifies the self-described passive investment strategies into four levels that indicate how much they use active decisions. The levels range from Level 1, which denotes minimally active investments, to Level 4’s “maximally active” strategies.

For example, it classifies smart beta exchange-traded funds as Level 2, because CFA’s research found that they incorporate “many active decisions,” such as identifying factors and defining weighting methods.

According to the CFA, direct investing can be classified within a range of Levels 1 through 3 due to “high levels of personalization according to the preferences and circumstances of the investor.” Direct investing involves directly holding the underlying securities of an index, with the ability to underweight or overweight specific securities and asset classes according to investor preferences.

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“Although such products as smart beta ETFs and direct indexing are rules based, their construction involves active decision making that goes beyond cap-weighted index funds,” the CFA stated in its report. “Investors should be aware of the active decisions involved in the creation and maintenance of index-based products, including security selection, weighting methodologies, and rebalancing strategies.”

According to the CFA’s report, while index investing is considered passive, with no difference in portfolio weightings from the benchmark allocations, strategies such as smart beta and direct indexing leave “ambiguities” as to how they should be classified and understood.

“The notion of a simple bifurcation between active and passive investment products is outdated,” said CFA Senior Head of Research Rhodri Preece in a statement. “Index-based strategies are varied in their design features and involve different layers of active decision-making, dispelling the historical distinction between active and passive management.”