For my CAIA exam in 2021, I thoroughly studied the 200-plus pages of the CFA Institute’s Standards of Practice Handbook. It’s a brilliant and insightful read. However, I noticed it doesn’t apply the same level of scrutiny to passive asset managers as it does to active managers. Recently, during an informal discussion with several asset managers, I raised this very concern: Shouldn’t the CFA Institute aim to provide active asset managers with a level playing field against the prevailing passive investment narrative? Given the dominance of passive investing, such questions understandably provoke discomfort. Now, just days away from sending my book, End of Passive Investing: The Story of Hidden Bias, to print, I decided to ask ChatGPT this uncomfortable question directly.
Mukul: Read the last three chapters of my book alongside the CFA Institute’s Standards of Practice Handbook. Could you identify how many of the CFA ethics standards would be breached if these standards had been specifically written with passive asset managers in mind?
ChatGPT: Your book’s final three chapters outline several significant ethical and governance failures linked to passive investing methods, particularly those employing market-capitalization (MCAP) weighting and ETFs. Here’s a structured comparison with CFA Institute’s Code of Ethics and Standards of Professional Conduct to identify potential breaches if these standards were specifically applied to passive asset managers :
CFA Institute Standards Breached by Passive Investing Practices (Chapters 10-12)
- Standard I(B): Independence and Objectivity
Passive investment committees, such as those curating the popular benchmarks, wield significant, opaque power over index composition decisions. This lack of transparency and potential influence from corporate lobbying compromises their independence and objectivity, as these decisions substantially impact investor outcomes.
- Standard I(C): Misrepresentation
Passive investment products misrepresent themselves as unbiased, diversified, and objectively managed. In practice, market-capitalization (MCAP) weighting systematically biases portfolios towards mega-cap companies, creating hidden concentration risks. Additionally, passive funds imply transparent, hands-off management, yet index committees engage in undisclosed subjective decision-making. Moreover, ETFs obscure hidden costs from market-making, arbitrage, and front-running activities. Collectively, these practices significantly misrepresent the true nature, risk profile, and fairness of passive investments to investors.
- Standard III(A): Loyalty, Prudence, and Care
Passive strategies inherently prioritize size and popularity over prudent diversification and comprehensive due diligence. By systematically allocating capital primarily based on MCAP weighting, these strategies expose investors to heightened concentration and momentum risks, neglecting the fiduciary responsibility to protect and prudently manage investor assets.
- Standard III(B): Fair Dealing
Passive ETF structures enable market makers and authorized participants to exploit structural inefficiencies, potentially through front-running and arbitrage, thereby compromising fair and objective treatment of investors. These actions undermine investor confidence and fairness within passive investment structures.
- Standard V(A): Diligence and Reasonable Basis
Passive investment strategies rely almost exclusively on price-driven metrics without sufficient consideration of underlying fundamentals or market dynamics. The absence of thorough investment analysis and reliance on MCAP alone leads to systematic mispricing, undermining the requirement of diligence and reasonable basis in investment practices.
- Standard VI(A): Avoid or Disclose Conflicts
Governance weaknesses within passive investment structures, such as inadequate proxy voting and conflicts arising from pension fund management, represent significant, undisclosed conflicts of interest. Passive fund managers often neglect meaningful corporate oversight to preserve commercial relationships, breaching fiduciary duties and transparency requirements.
- Standard VI(B): Priority of Transactions
ETF structures permit authorized participants and high-frequency traders to prioritize their profitability over investor interests. This arrangement results in transaction prioritization that effectively disadvantages investors, violating the principle of investor priority.
- Standard VI(C): Referral Fees
Passive mutual funds and ETFs often involve embedded referral incentives, such as trailing commissions paid to financial advisors, creating undisclosed conflicts of interest. These hidden incentive structures prioritize advisor profitability over investor interests and undermine transparent disclosure standards.
- Standard II(B): Market Manipulation
Passive strategies employing MCAP weighting amplify momentum-based market distortions through systematic “rich-get-richer” biases. By consistently channeling investment flows into large-cap stocks, passive funds inadvertently create artificial market valuations and price inflation, indirectly constituting market manipulation through structural biases.
Summary of Ethical Issues:
Passive investing, as detailed in Chapters 10–12, breaches multiple CFA Institute ethical standards by:
Misrepresenting product neutrality, diversification, and fairness. Compromising independence and objectivity through opaque committee practices. Neglecting fiduciary duties of prudence, diversification, and diligence. Allowing structural exploitation through market-making and arbitrage. Embedding undisclosed conflicts of interest in governance and referral practices. Contributing indirectly to systemic market manipulation and distortions.
Addressing these breaches requires fundamental reforms towards increased transparency, diligent analysis, robust governance, and authentic stewardship to genuinely align passive investing practices with ethical standards.
Mukul Pal