Proponents of passive investing like Roy Komack, president of Family Financial Architects, Inc., claim it produces better returns at less cost to clients, than actively managed investments. In fact, approximately 60 percent to 70 percent of the $100 million the Natick, Mass. firm manages for individual investors is in passive strategies. However, in August 2005, Family Financial made a change to its passive focus. Client assets are now being shifted from a traditional index fund into new funds employing a new methodology called fundamental indexing, which de-emphasizes market cap weighting in favor of other metrics.
Thus far, close to $15 million of Family Financial’s assets under management has been shifted from the iShares Russell 1000 Index Fund into either the PowerShares FTSE RAFI US 1000 Portfolio or the PIMCO Fundamental IndexPLUS TR Fund. The firm’s decision to invest client assets in fundamental indexing, Komack says, was based on the belief that it was a more sensible approach to passive investing than traditional capitalization-weighted indices.
Passive investment strategies provide numerous compelling advantages for clients including broad diversification, low turnover, full market participation, greater after-tax returns and lower management fees. “Academic research makes overwhelmingly clear the benefits of having the majority of investments in passive strategies,” says Steve Condon of Truepoint Capital in Cincinnati, Ohio.
However, many observers point out that traditional passive investing strategies are also inherently flawed. Traditionally, portfolios utilizing passive investing strategies weight securities based on market capitalization. Markets, of course, tend to have inefficiencies, so stocks priced above true value will have erroneously higher capitalization and higher index weighting. “Capitalization- weighted indices systematically overweight overpriced securities and underweight under priced securities,” says Robert Arnott, chairman of Research Affiliates LLC in Pasadena, Calif. “Why should we want to own more of a stock merely because it’s overvalued?” Everyone knows that buying high and selling low is bad investment strategy, but that is exactly what happens in market-cap index funds because they reflect current market trends, explains Jerry Moskowitz, a managing director at FTSE America in New York.
Assuming that investors always act rationally also makes cap-weighted portfolios vulnerable to market bubbles and corrections. The point is, says Moskowitz, that markets do not always reflect real economic activity. During the technology bubble in the 1990s, for example, cap-weighted indices assigned too much weight to overvalued Internet stocks. FTSE rebalances its index funds annually, explains Moskowitz, so in 2000, technology industry stocks went from comprising 20 percent of index portfolios to 30 percent.