QOTD: Is Fundamental Indexing Passive or Active?

ETF.com: "I've seen the term "quasi-active" thrown around in reference to smart-beta indexes. Do you think that's an accurate term?"

Rob Arnott: Absolutely. If you view the Fundamental Index strategy or any of the smart-beta strategies through the prism of finance theory—which centers on the cap-weighted market as the starting point for everything—they are all active strategies. They don't actively choose stocks based on some analyst's view; they choose stocks based on some algorithm. And if that algorithm severs the link between price and the weight in the portfolio, it appears through extensive historical testing, which adds about 2 percent per year all over the world, spanning decades. Well, that's cool. And it doesn't have to be the Fundamental Index method, it can be darts.

So, are these strategies active? From the vantage point of the market, which is cap-weighted, of course they're active. Turning it around, is the market active relative to the economy? Absolutely. The market is making enormous active bets on which companies are going to be extraordinary in the years ahead. Look at Facebook, Tesla, Twitter. They all carry valuations that would require monumental growth in the years ahead merely to justify current prices. Is that growth going to happen? Sure it could, but the market is already betting that it's a foregone conclusion, so the market is making big active bets, not relative to itself, but relative to the broad macro economy.

The Fundamental Index looks passive relative to the macroeconomy, and active relative to the market. The market looks active relative to the macroeconomy, and by definition, passive relative to the market itself.

Rob Arnott is the father of fundamental indexing, in many ways (at least a courtroom said so not long ago), so it is interesting to hear this take on how even a passive market index, at its core, is also being active in relation to the economy. I’m inclined to agree – there isn’t anything that could ever be truly passive so long as humans set the weights and drive prices. There are only degrees of activity and controllable costs.

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