Passive management is rising in popularity. Assets in passive funds, including ETFs, are growing substantially while actively managed funds, especially those invested in equity markets, are losing assets. However, it's unsure that the implications of managing assets passively are fully understood. Often, passive management is seen as the obvious choice in all circumstances, but is this true?

Passive management is defined as a portfolio management technique in which a certain index is replicated. Often, the index includes securities of a certain segment of the financial markets and weights the securities based on their market capitalisation. The use of these portfolio construction methodologies in particular has profound implications that are not always fully known.

The construction process involves market capitalisation indices overweighting expensive stocks and underweighting cheap stocks. The same goes for expensive sectors and regions, e.g., the share of IT stocks in standard equity indices was high in 2000 during the tech bubble and low afterwards in 2003. A similar counterintuitive effect applies to the financial sector before and after the Great Financial Crisis of 2008. Intuitively, intelligent investors would opt for inverse allocations …

The consequences of using market capitalisation in fixed income indices are even more far-reaching. When, for example, interest rates are low, borrowers tend to issue longer-term debt. A market capitalisation index will, as a consequence, have a high average duration when interest rates are low and, inversely, a low average duration when yields are high. This, again, is not what intelligent investors are expected to do. Furthermore, highly indebted borrowers are proportionally overrepresented in standard bond indices while most bond investors prefer to invest in high-quality debtors.

Apart from the aforementioned aspects, many investors are reluctant to blindly invest in any company without first scrutinising the business model and ethical aspects. Standard indices, however, invest in all companies, including those involved in, for example, cluster ammunition, anti-personal mines, the violation of human, labour or environmental rights, or corruption.
Despite all these arguments, passive management still seems to be considered by some as a kind of natural law that is not subject to accountability. But the reality is that investing passively is a deliberate choice to apply an indiscriminate market-capitalisation portfolio-construction methodology. Hence investors in standard passive funds need to be aware of all the risks involved in applying this method. Choosing to invest passively needs therefore to be considered in essence as an active choice!
This does not mean that passive investments cannot be a valid choice. By choosing the right index to replicate, passive management can even be a highly effective complement to a portfolio. But it is very important to assess the underlying index. It is Candriam's conviction that, firstly, an ESG assessment should be integrated and, secondly, alternative portfolio-construction methodologies should be considered. Let's briefly outline these 2 elements.

Since most reasonable investors prefer some selectivity when choosing appropriate investments, ESG criteria should be applied to screen potential instruments. Candriam's research indicates that avoiding companies that score adversely on an ESG assessment improves risk-adjusted returns. An optimal balance between a high degree of ESG selectivity on the one hand, and portfolio diversification on the other, should be obtained. No optimal equilibrium point exists and largely depends on the preferences of the investor.
Many alternatives exist to determine the weightings of eligible securities. A fundamental weighting reflects the economic relevance of a company based on some of the most important financial metrics, such as revenue, profit, cash flow and the size of the balance sheet. Using these metrics avoids investing in expensive stocks and brings an intuitive logic to the portfolio. On top of this methodology, factor-investing tilts such as value, size and low volatility can also be used. A wide range of academic literature exists to support the added value of these factors. As long as the transaction costs linked to the implementation of these factors are controlled, and that different factors are combined into a multi-factor approach, it can be a very powerful addition to any index.
In conclusion, it seems clear that passive investing requires much more analysis that might at first be expected. Additionally, it turns out that most standard indices, based on market capitalisation, are somewhat flawed and hence are not always optimal choices for rational investors.