The Hidden Costs of Passive Investing

The idea that capitalization-based indexes are costless is “lunacy,” according to Research Affiliates.

Passive investments may not be quite as cheap as they appear.

According to a report by Research Affiliates, the gross returns of index investments are “materially depressed” by hidden trading costs.

“You don’t see these costs in performance attributions, unbundled management fees, or even standard trading costs analyses,” wrote Research Affiliates Director Michael Aked. “The fact that they are unobserved doesn’t mean that they don’t exist, can’t be measured, or shouldn’t be taken into account when selecting an index strategy.”

These hidden costs are implicit trading costs, or the “loss of performance due to transactions occurring at prices that would not have prevailed if investors didn’t need to enter trades.” When a stock becomes a member of an index, investors pay a “substantial” premium.

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“An index is just a model portfolio, and it cannot be implemented above and apart from the laws of managing money,” Aked wrote. “To attract sellers for stocks you wish to buy, you have to pay more. To attract buyers of stocks you wish to sell, you need to ask for less.”

These price differentials add up so that the cost of implementing capitalization-based indexes is “meaningfully higher” than that of well-designed smart-beta offerings, he continued.

Furthermore, Aked argued that this costly construction of indexes can mean they are essentially active management.

“Index designs run the full gamut, from highly systematic, rules-based procedures to largely discretionary, committee-based processes,” he wrote. “In every case, the explicit selection criteria, weighting rules, and committee decisions directly affect indexes’ active shares.”

While trading costs can be expensive, cap-weighted indexes are self-adjusted, meaning they minimize that particular type of cost, Aked noted. However, he continued, that does not mean they should be viewed as costless.

“It’s lunacy to believe that the implementation of popular capitalization-based indexes is costless, that their negative selection and weighting bias is zero, or that their implicit trading cost as a percentage of aggregate assets is currently below that of well-designed smart-beta offerings,” he concluded.

Home > News > Manager Selection > ‘Scrutinize Hedge Funds Now,’ Endowments Told

Manager Selection January 22, 2016

‘Scrutinize Hedge Funds Now,’ Endowments Told

Investors must ensure they are holding the right funds for their needs, says Mercer.

Nonprofit investors should scrutinize their hedge fund programs after the sector failed to keep up with equity market rallies in recent years, according to Mercer.

The consulting firm published a checklist for endowments and foundations (E&Fs) detailing several areas in need of attention, including liquidity, benchmarking, and hedge fund allocations.

“Endowments and foundations are among the largest users of hedge funds, embracing a wide variety of strategies in pursuit of stronger returns and managing portfolio risk,” Mercer said. “Given the strong equity markets in the past seven years, many hedge fund strategies haven’t generated the results that many E&Fs were expecting. E&Fs should take the opportunity to revisit their hedge fund portfolios and confirm the role and expectations for hedge funds.”

According to Preqin, the sector posted its worst calendar year return since 2011 last year: The data provider’s all-strategies hedge fund index gained 2% in 2015.

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“The hedge fund industry has been exposed to much of the financial turmoil of 2015, from the continuing fall in commodities prices to the loss of confidence in the Chinese stock market,” said Amy Bensted, head of hedge fund products at Preqin. “These difficulties have created very difficult conditions for many firms, and left some investors questioning the ability of the industry to properly hedge losses in other markets.”

However, in an outlook report for the hedge fund industry published earlier this month, eVestment forecast institutional investors would drive inflows of $50 billion to $60 billion in 2016.

Peter Laurelli, head of research at eVestment, wrote that hedge funds as a whole should see growth this year, “barring the occurrence of an outlier event.”

“Inflows should be supported by the continuing slow and steady reallocation of assets from traditional to alternative strategies,” Laurelli said. “In spite of some high-profile negative hedge fund news during 2015 and underwhelming performance in some segments, other hedge fund segments and individual hedge funds performed well, making hedge funds of interest to institutional investors looking for investment diversity.”

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