Determining prudence is often a function of peer comparison from quantitative and qualitative criteria. We have already established key quantitative criteria (returns, fees) are generally attractive for passive products. Moreover, the key elements of qualitative criteria are often given a pass from investment consultants for passive investments.
For example, there have been several portfolio manager changes in large mutual funds over the past year. One of the largest active bond funds in the world recently had a shakeup in management which dominated financial news cycles for weeks. By comparison, some of the largest passive equity funds changed their management with hardly anyone noticing or caring. Both products will have failing grades with fiduciary screening tools (like the fi360 toolkit) which expect organizational stability, but nobody cares about the passive fund manager changes. Why? It is because the investment decisions, which are ostensibly the responsibility of a portfolio manager, are actually defined by a transparent, predictable set of rules.
The perception of a lower threshold for due diligence for passive managers is true, but we are concerned this complacency can lead to significant mistakes. Rather, the philosophy and process for passive funds are, seemingly, so well-defined these products are often improperly vetted. First, there are marginal differences between competing passive products: fees, tracking error, and market depth (important for option trading). However, there are overlooked elements within passive product operations. For instance, some of the largest indexers provide lending of their securities to provide additional alpha, but the implications of this practice is ignored. Another example: one of the largest wirehouse passive bond funds has a time period of surprising under-performance relative to their index, not because of the underlying bond positions, but because of the cash management vehicle’s investment into short term bank and mortgage backed securities during the 2008 financial crisis (i.e. some of the money market fund assets which “broke the buck”).
Passive products can be a great complement to a portfolio – but they shouldn’t get a free pass.