The Greatest Advantage of Passive Management over Indexing

(This week, we're looking at the differences between indexing and passive management. Yesterday, we reviewed major differences between passive management and indexing. Today, we'll cover an area where passive asset class funds have the best chance of providing value over index funds.)
Perhaps the greatest area for passive asset class funds to improve on the returns of index funds comes in the small-cap asset classes. Not only do small-cap stocks have large bid/offer spreads, but the low levels of liquidity in these stocks also lead to large market impact costs for active fund managers attempting to quickly get into or out of these stocks. It's much harder for an index fund to take advantage of the willingness of an actively managed fund to absorb market impact costs as the price of a fast exit from a stock they believe is going to fall.

The reason is that index funds must hold the appropriate market cap weighting for each stock, or run the risk of tracking error (and no longer being an index fund). A passive asset class fund has no such limitation. A fund might establish a rule that it would be willing to randomly hold as little as one-half to as much as two times the appropriate market cap weighting for any one stock.

How It Works XYZ is a small-cap stock with a market capitalization of about $500 million. The stock only trades about 100,000 shares a day. The stock currently trades at 10 bid and 10 ¼ asked. Thus, about $1 million of the company's shares change hands daily.

Active fund XABCX wishes to sell $5 million of the stock. It knows that trying to sell such a relatively large block of stock will rapidly drive down the price, and it will take a long time to get out. In the meantime, it wants to buy another stock it expects to rise in value. To sell quickly (get out of the stock it currently owns and raise the funds to buy the future winner immediately), the active fund must accept a discount.

A passive fund is contacted to see if it's interested in buying the stock. The fund finds that it should own $5 million based on market-cap weighting, and thus could buy the whole block. The passive fund bids 9 for the stock.

Now obviously, it won't win every bid with this type of discount. The seller might not be willing to sell at that steep a discount, and/or there might be competition for that block willing to bid at a somewhat higher price. However, it will win some. This block trading can turn the high trading costs of small-cap stocks into an advantage by creating opportunities for negative trading costs. This is because the evidence is clear that active funds have no insight into stock price movements - when they sell, there's no information in the trade. Thus on average the stock bought in a block trade at a discount will trade the next day at the same price, relative to the market, that it traded at prior to the block trade.

Hold Ranges In addition to block trading, passive funds have another advantage over index funds in terms of trading. As was stated earlier, when a stock leaves an index, index funds must sell it. Passive funds can use hold ranges to reduce turnover. However, the stock might ultimately have to be sold. Instead of hitting the bid, passive funds can leave working orders with dealers or market makers in an attempt to improve the execution.

In the above example with stock XYZ selling at 10 bid 10 ¼ asked, a passive fund might leave a working order to sell at 10 1/8. Of course, it runs the risk that the stock will fall. However, some stocks will rise, and it will get a better price than if it hit the bid. On average, it will likely improve the average price received. The same thing is true for buys.

Follow the series:

• The Difference Between Active Management and Passive Management
• 5 Differences Between Indexing and Passive Management
• The Greatest Advantage of Passive Management over Indexing
• The Benefits of Passive Management Without Indexes

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