Passive Index Funds Are Lagging “the Market” This Year

Whoa, what a weird headline, eh?  How is it that a passive fund could possibly underperform you ask?  Well, as I’ve long noted the term “passive” is a misnomer.  There is actually only ONE truly passive index in the whole world and that is the portfolio that comprises all of the world’s currently outstanding financial assets.  Of course, we can’t buy that portfolio because it doesn’t exist in any realistic product.

What most people on Wall Street do is abuse the term “passive” to create a distinction between stock pickers and index funds.  So, we often hear about how the S&P 500 is a “passive index”.  Well, not really.  It’s actually an actively selected group of 500 American companies out of millions in the world.  It represents about 75% of US stock  market cap and US stocks only represent about 15% of the world’s outstanding financial assets.  So, when someone says the S&P 500 is a “passive” index they’re actually referring to an arbitrarily chosen index of about 12% of the world’s financial assets and implying that, by owning this index, that you’re broadly diversified….

Anyhow, I am a macro guy so I think big picture.  I mean the WHOLE damn picture.  So, when someone refers to “the market” my first question is usually – well, WHICH market are you referring to specifically?  The reason I ask that is because people who talk about “the market” are actually slicing up the global asset portfolio into pieces.  They’re calling the S&P 500 “the market” or they’re calling US bonds “the market”.  But that’s pretty sloppy.  There’s actually only one “market” in the aggregate and that’s the global financial asset portfolio which is comprised of all of the world’s financial assets.   But most people have gotten into the nasty habit of taking short cuts and refer to “the market” and “index funds” as though they are all encompassing when they are clearly not.

Now, what’s interesting about all of this is not just how so many people use a micro perspective to discuss this macro concept.  No, what’s really interesting to me is how an entire industry has come to fall for this idea that certain slices of the global asset portfolio, which are actively selected based on some specific criteria no different than what a stock picker might do, are suddenly “passive”.  The S&P 500 is no more “passive” than the stock picker who buys and holds 500 of his/her favorite stocks from the Wilshire 5,000.

To emphasize this point, we can take the daily “underperformance” headlines about “active” managers and turn them on their heads.  For instance, do you own the ever popular 60/40 total stock/ total bond index portfolio?  If you do, you’ve underperformed the market this year.  But wait, you own index funds, right?  You can’t underperform.  Right?  Wrong.  By picking this allocation you chose to actively deviate from the aggregate global portfolio which is roughly a 45/55 stock/bond portfolio at present.  The 60/40 has generated about a 4.2% return this year (that’s using total world and total bond).  Meanwhile, the global asset portfolio has a market cap weighting equivalent to about a 45/55 stock/bond portfolio at present.  And that portfolio has generated an equivalent 4.2% so far this year.  But the 60/40 took a lot more risk to get the same return.  With a standard deviation of  7.8 and Sharpe ratio of 1.06 the 60/40 looks like a far worse portfolio than the 45/55 which generated the same return with a standard deviation of 5.9 and Sharpe ratio of 1.26.  But wait.  It gets worse.  You had to pay an expense ratio of 0.15% on average to hold that 60/40 so you actually generated about a 4.05% return.  And don’t get me started on taxes…Oh dear, you’ve now underperformed on a nominal AND risk adjusted basis.  You should probably fire yourself for being a bad asset picker!

Ironically, all those 60/40 indexers who made the active decision to deviate from the one true passive index are actually underperforming it.  So now they can join hands with the active managers they regularly demonize and rest easy knowing that there really isn’t a free lunch on Wall Street.