This is the message you will receive if you tell the Bogleheads that their approach is misleading – you’ll get censored by their moderators. I didn’t think I was doing anything all that insulting. Yes, I was on their site saying that the idea of “passive indexing” is misleading. But most of the Bogleheads (the one’s with no vested interest in the branding behind “passive indexing”) should have no problem calling themselves active asset pickers – it changes nothing for them.
Now, I was simply explaining how there is one portfolio of global financial assets in the aggregate (a simple fact) and how anyone who deviates from that market cap weighting is making an active asset picking decision (a simple fact). I explained it this way:
A buy and hold stock picker picks thin slices of the aggregate pie by choosing specific securities within the aggregate of financial assets. The “passive indexer” broadens his/her horizons and picks a fatter piece of the pie in a buy and hold approach. Importantly, the “passive indexers” don’t advocate buying the whole pie which would be roughly a 40/60 stock/bond portfolio at present. No, they advocate (for various active reasons like “factor tilting” or personal reasons) that you should deviate from cap weighting.
I was further explaining that the very foundation of “passive indexing” is grounded in general equilibrium theory and ideas like rational expectations – ideas that are virtually useless for practical application. If I am right then this has important implications for portfolio management because it would mean that some degree of dynamism and asset picking in a portfolio is not just useful, but totally rational given that the financial system and the global asset portfolio is itself quite dynamic and actively evolving.
Now, some of this is quite difficult to understand because I am tying the economics directly to the finance, but the internal inconsistencies behind passive indexing really bother me. If the world of financial assets is dynamic, quite actively changing on a daily (literally) basis and doesn’t resemble general equilibrium then how can a static portfolio approach like “passive indexing” be appropriate at all times? It just can’t. Some level of dynamism is rational in a portfolio even if it means reweighting on occasion to account for changes in the global market cap portfolio. This obviously annoys some people because there is a lot of money to be made by pitching the idea that indexers are inherently different than stock pickers and diminishing the difference will diminish the value of the concept of “passive indexing”.
Anyhow, I’ve decided to write a formal paper about this topic because I think it is incredibly important. The entire concept of “passive indexing” is somewhat misleading. It draws a distinction between asset pickers and stock pickers when that distinction is far less meaningful than one might think. This shouldn’t diminish from some of the useful concepts of indexing (like taking a long-term view, reducing costs, reducing taxes, etc), but when your entire portfolio process is constructed around misleading terminology and false precepts then it’s worth blowing up that foundation and trying to start over again.
I’ll be back with more on this in the coming months….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.