John Rekenthaler of Morningstar wrote a good piece today pointing out that the “active” vs “passive” debate is the wrong question. He’s right. We really shouldn’t be concerned at all with these labels. After all, they are relatively meaningless marketing terms that have been constructed for no other purpose than to differentiate one product from another. But there’s a more worrisome trend at work here and I think it deserves a lot more attention. The fact is, most of the adherents of “passive” indexing are not only misconstruing the discussion, but they are working with an underlying model that is inherently flawed.
As I’ve explained in detail in several past posts (see below), there is nothing in the world of investment products that allows you to be a pure “passive indexer”. That is, the ONLY pure indexing approach is buying the Global Financial Asset Portfolio and taking “what the aggregate market gives you”. This portfolio isn’t available though. You can come close to replicating it by building a 40/55/5 stock/bond/REIT portfolio, but you can’t achieve it perfectly.
What most “passive indexing” strategies really do is pick assets. That’s all they are. For 30 years they have constructed a clever marketing pitch berating “stock pickers” without thinking through their own approach entirely and realizing that they are also asset pickers inside of a broader aggregate. “Passive indexers” determine an asset allocation by taking all sorts of theoretical underpinnings and then make an implicit (some might say naive) forecast about the future that is the precise equivalent of saying they can “beat the market”. Do you own a “passive 60/40” stock/bond portfolio? You are declaring to the world that you think stocks will outperform the (approximate) 40/55/5 stock/bond/REIT allocation of the GFAP. You are saying you are smarter than “the market”. You are saying you can pick assets better than “the market”. You are an active asset picker.
More importantly, anyone who understands the GFAP from macro perspective knows that it’s an ex-post construction of an index that is basically a rear-view mirror bet hoping that millions of issuing entities are making “efficient” decisions based on the assets they’ve already issued (there’s a contradiction in the Efficient Market Hypothesis there that is the width of a Mack Truck). Of course, there are times, like the last 25 years, when the GFAP is not just wrong, but tremendously wrong (buying the purely passive 60/40 stock/bond GFAP portfolio in 1980, for instance, generated far worse risk adjusted returns than a bond heavy portfolio did).
Now, don’t get me wrong here – a lot of the general message underpinning the concept of “passive investing” is great. I love indexing. Diversification is tremendously important. Costs are HUGELY important. Trading can be terrible for your wealth. But “asset picking” (which is what all asset allocation ultimately comes down to) is totally necessary. It’s the only way we can construct portfolios that align our risk tolerance and financial goals with a certain set of appropriate assets.
So yes, it’s time to dump the “active vs passive” jargon. It’s just marketing terminology sold by firms with a vested interest in one or the other. More importantly, if your advisor or “expert” investor friends use the term “passive investing” they probably haven’t thought all of this through from a macro perspective which means that the entire foundation and rationalization of their approach could be flawed.
- Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance
- Debunking some Common Investment Myths
- We Are All “Active” Investors
- Most Index Funds are Macro Funds
- Putting the “Underperformance” of Active Managers in Perspective
- Of Course 80% of Active Managers Underperform the Market!
- There’s no Such Thing as “Forecast Free” Investing
- The Importance of Understanding Your Implicit and Explicit Forecasts
- The Importance of Understanding Your General Portfolio Framework
- The Contradiction of “Passive” Index Fund Investing
- Is the Global Financial Asset Portfolio the Perfect Indexing Strategy? – Part 1
- Is the Global Financial Asset Portfolio the Perfect Indexing Strategy? – Part 2
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.
How come you’re the only person pointing this out? How has an entire industry missed this fact for so long?
You are right but wrong.
Yes, allocating aset classes to a portfolio and buying products which mimic indices is an active choice, but it is frequency of allocation between classes in changing proportions and moving between individual assets within a class that defines, in a general sense, the active investor.
Many assive investors aren’t trying to beat the market, they are trying to avoid the big dips that cause anxiety and panic selling and to reduce leakage of capital and returns to the Finance sector. This is particularly important during a time of low yields when an ongoing fee can reduce overall performance on a balanced fund by say 20% (gross return 5% less a fee of 1% of gross assets).
By the way your example of passive investing fails to mention international diversification within asset classes which could be a further point of balancing.
Rember that many higher performing funds have pointed out that their clients change over time and that many sell during crises/crashes and reallocate to less volatile investments with what later proves to be bad timing and thereby have poor performance as individuals. A passive approach to a balanced portfolio, perhaps with quarterly rebalancing back to the original portfolio asset mix is more likely to avoid this common mistake.
Among the general populace, the terms active and passive are useful shorthand to get started in a conversation.
The GFAP is dynamic and international (hence the “global” name!). It changes every year, every month and probably every minute. The purest index in the world is actually very active by definition and relies on the decisions of the underlying entities (who are all making forecasts). So I don’t know how well any of this actually translates to anything remotely “passive”. There’s really nothing “passive” about anything going on in the GFAP or any other portfolio. This is a fact. Not a theory.
And let’s not skew the discussion here. Most “passive” investors are claiming to be taking just the market return as opposed to trying to “beat the market”. That’s the essence of the “passive” marketing pitch. But that’s not what they’re really doing. The vast majority of asset allocators are actively picking assets that they believe will generate better returns than the GFAP. They are making active bets that they claim will “beat the market” whether they know it or not. They’re picking aggregates inside the ultimate aggregate. It’s no different than picking stocks inside an aggregate except that it’s a slightly more efficient way to pick assets.
Now, most of them never thought of indexing like this to begin with so they didn’t realize this, but that’s indeed what they’re doing. In short, there’s almost no difference between what a long-term “value” stock picker does and what a “passive indexer” does except for the fact that the “passive indexer” spends a lot more time claiming to be doing something that is totally different while pointing to studies about how “active” managers underperform (almost all of these studies don’t benchmark correctly, btw, so they’re mostly misleading as well)….
Boat loads of time and money have been spent on cleverly depicting “active” managers as something totally different from “passive” index funds users. And the companies that benefit from the growth of “passive” index funds have demonized stock pickers and anyone who tries to “beat the market” for years. But it turns out that anyone who implements an asset allocation approach is actually active in much the same way that stock pickers are – they just so happen to be implementing an appraoch that is generally more efficient than stock picking because it’s CLOSER to the aggregate. In short, the idea of “passive indexing” is just a marketing ploy based on a relatively shaky foundation (the idea that we should just take what the market gives us).
I find the term “passive” to be deceptive and based on a misunderstanding of what one is doing when they allocate assets. It’s based on some irrelevant concept of the Efficient Market Hypothesis and all that. I have a feeling the term was invented to create a distinction in financial products so some firms could differentiate themselves from more “active” managers. Personally, I think the term “passive investing” is rather useless and misleading. Heck, I’d consider my personal approach rather “passive”, but I don’t think this term applies to what I do in any useful sense.
If you want to emphasize low fee, diversified, long-term indexing there are ways to do it without claiming that you don’t make forecasts or pick assets (which are both lies or misunderstandings by anyone engaged in constructing a portfolio).
Active vs. Passive is, as Cullen notes, just aggregating over different subsets of financial assets on different time frames. Within the limits of applying the models of Physics to Economics it’s a requirement for there to be a spectrum of agents from active with time constants in the microsecond range to active with time constants in the multi-decade range and it’s also nearly a requirement that transactional flux increase in some manner inversely related to time constant. If you want semi-efficient markets you have to have very high transactional flux for some instruments.
James Osborne, CFP®
Ok, I’ll bite. (BTW good call on moving to Disqus).
This: “Do you own a “passive 60/40″ stock/bond portfolio? You are declaring to the world that you think stocks will outperform the (approximate) 40/55/5 stock/bond/REIT allocation of the GFAP. You are saying you are smarter than “the market”. You are saying you can pick assets better than “the market”.”
I take issue with. The rest of it I generally agree with, but you knew that. You are stating that assuming stocks will outperform the broad GFAP (and, in essence, bonds) is saying that you are smarter than the market. That means that all assets must have the same nominal long-term returns, which is clearly false. To moving away from the GFAP is simply stating that you have a difference risk profile/tolerance than the “average.” Which makes perfect sense. I am much more willing and able to take equity risk than an 80 year old pensioner or an insurance company or a bank or a government holding foreign reserves. As a result I anticipate that I will earn higher returns than the GFAP over a long period of time. I don’t think that means I think I am smarter than the market, just that I am willing to be exposed to more volatility. Yes, there are unusual periods where equity risk does not pay off (say at the end of a 30 year bond bull and a nasty stock bear) but historically odds favor higher stock returns.
So: are you claiming that all assets in the GFAP have the same nominal returns, or is it possible to earn higher returns by choosing riskier assets?
When you pick your 60/40 portfolio in today’s environment you are saying that you can generate a better risk adjusted return than the 40/55/5 GFAP. You’re basically saying that stocks are less risky than the market thinks they are and that you think you can generate superior risk adjusted returns by owning the 60/40 over the GFAP. My guess is that people owning a 60/40 in the future will be taking much more risk than they think because the stocks will be ultra volatile and the bonds will generate sub-par returns. So the risk adjusted returns of the 60/40 in the next 30 years will look NOTHING like they did during the last 30 years. In other words, the GFAP will essentially be proven right in that an overallocation towards equities will generate a higher nominal return, but only by betting on the beta of the stock side of things (which is totally fine for some investors as you mentioned).
Now, there are several potential problems with all of this:
1) We are defining “risk” as standard deviation.
2) We are not accounting for the way investors actually perceive risk (which is not as volatility).
3) The GFAP is dynamic because asset issuance is always adapting to the changing environment. So using a static allocation doesn’t translate to the real-world in any meaningful sense. We have to, BY DEFINITION, be forward looking and dynamic in our asset allocation choices because the firms issuing the underlying assets are doing the exact same thing!
This, in my opinion, is one of the biggest problems with the way academics have constructed this model of the financial world. Using standard deviation as risk does not translate at all to the real-world. It’s a nice mathematical construct, but it makes no sense to use standard deviation to construct portfolios because our clients don’t see “risk” as being volatility. So that opens up a whole other can of worms. It doesn’t mean quantifying risk is useless, but it does mean that when you construct a portfolio you have to consider many more variables than what is being considered in this exercise.
Assuming you could CAP weight every exchange traded security, would that be passive investing? I very much agree with the premise that the minute you overweight small cap value – or any other sector – you are no longer a passive investor.
Yes, if you could cap weight every instrument and maintain it according to the GFAP then you would be about as close to “passive” as possible. That would require a good deal of upkeep and maintenance though so I don’t know how “passive” it would really be.
The main point here, is that there’s really no such thing as a passive portfolio because the underlying portfolio of outstanding instruments is dynamic by nature. So there is literally no one in the world who can maintain a perfectly passive portfolio. You can set a portfolio and forget it, but then you’re likely deviating from the GFAP which means you’re being active again….Trying to be perfectly passive is a failed endeavor.
It’s much smarter to understand risk and establish an appropriate portfolio that is diverse, low fee and dynamic to some degree. It’s the only way one can logically invest given the realities of a dynamic financial asset world….
James Osborne, CFP®
I disagree that by taking a 60/40 weighting you are saying you can generate a better risk-adjusted return. A higher nominal return, hopefully, but not better risk-adjusted. Ideally it would be the same risk-adjusted but we know that the odds of that are fairly small.
I also disagree that by overweighting stocks you’re saying stocks are less risky than the market thinks. Perhaps you are just more willing to take that risk than “the market” again because you likely have a different end goal in mind than many institutional asset owners.
Of course here you are making your own assumptions by saying stocks will be ultra-volatile (can’t be sure of that, but it is possible) and bonds will generate sub-par returns (looks that way now, but a quick jump in rates could change that in 3-5 years).
Agreed on all other points, volatility is an imperfect definition of risk but we have a hard time quantifying “risk” otherwise.
No, I am using the EMH framework. According to EMH the market has efficiently allocated assets. So in order to generate alpha you must find some inefficiency in the way they’ve been allocated. You have to claim you’re smarter than the market. That’s what a 60/40 portfolio does, according to strong form EMH, in an environment like today.
I disagree with that assertion. I disagree with EMH. I don’t think corporations or the “market” efficiently allocate assets. And I don’t think that asset allocators efficiently respond to the way corporations allocate their assets.
But if you were an EMH purist then you’d just buy what the market gives you and accept the market return without trying to generate any alpha. That’s what the GFAP represents.
I think we’re both basically agreeing that it’s wrong. So we actually agree even though we’re not totally on the same page….
James Osborne, CFP®
Yes we agree more than we disagree but we both knew that.But we’re not talking about alpha – I’ve never made a claim that 60/40 generates alpha. It generates beta, which is technically just as an “efficient” allocation of assets. EMH relies on an efficient “frontier” of assets, not a specific single point. So you could (in theory) have similar risk-adjusted returns along the frontier.
This is mostly semantics, but to me 60/40 vs. GFAP is about beta, not alpha.
Yes, but in a strong form EMH, nothing can be more efficient than the market cap weighted GFAP. The idea that a 60/40 can generate the same risk adjusted return as the GFAP is a rejection of EMH. So I would argue, by rejecting the GFAP allocation, you are (at least) implicitly claiming that you can generate a better risk adjusted return than the GFAP, but the reality is that EMH says you shouldn’t be able to because the market is the market and the market is always efficiently allocated. Of course, you can tweak that and say you’re just a weak form EMH or something, but that’s just a lazy excuse that’s the equivalent of “I don’t really know what the hell is explaining why my model is wrong so I’ll just say it’s imprecise”.
Plus, I would argue that the efficient frontier isn’t really “efficient” at all. It has the embedded assumption that you will make more money by taking more risk. But this is not necessarily true. In fact, in many countries it is a dreadful assumption (see Greece, Portugal, Spain, Italy, China, etc). The reason this is false is because “risk” is defined simply as standard deviation. An investment is not “risky” just because it is volatile. So that assumption is a fatal flaw in any portfolio model that relies on such a vague definition of “risk”.
I don’t think a 60/40 says you think you are smarter than the market.
I think it recognises that you are prepared to forgo some expected return to have lower volatility/risk of a major crash and a bad emotional reaction to it which precipitates a bad decision to sell low and miss a recovery.
I think a 60/40 says you believe you are more likley to follow this allocation as a long term strategy, rather than adopt a more aggressive approach that might have higher returns but where, knowing your human frailties, you are likely to abandon the strategy at the worst possible time.
When you talk of volatility as risk I think you need to be really clear that you are talking very long term volatility as an indicator of risk of significant variations in value, but even then I don’t thnik that the risk of investing after a 20% fall is as great as the risk of investing after a 50% rise.
A lot depends on whether you are considering the situation of a 20 year old just starting to invest with 40 years of contribution ahead of them, or of a retired person selling their house to invest in the stock market in September 2007 versus in March 2009. or a near retirement or recently retired person reviewing their current portfolio and considering adopting a radically different portfolio of asset classes and sub classes.
The impact of a significan fall after the allocation is vastly different in impact on the through retirement outcomes for the people involved.
I am just using a rigid EMH approach. You should take the total aggregate market return according to EMH. And as Cliff Asness notes, once you deviate from that market cap weighting you are no longer “passive”. You are now making an active bet. We can debate about the specific underpinnings driving the reasoning for a certain allocation, but we should all accept the reality that asset allocation is an active endeavor and that many people have trumped up this “passive investing” concept to mean something it really doesn’t….
You want to define passive investing as strict adherence to the Global Asset Financial Portfolio and you want to define risk strictly by standard deviation and demand the investor uses the GAFT without any allowances for risk (however he defines it.)
So, yes, in that case passive investing is a useless concept.
However, most people might want to use some kind of risk tolerance (not the one you want to use) and most investors might look with some suspicion on that GAFP as a marketing ploy in itself.
No. I don’t recommend the GFAP. My point is that no one can implement the GFAP and even if you could it might not be appropriate for you.
Further, I don’t define risk as standard deviation. That’s what academics do. I reject that thinking. I only use it in this post to show why it’s erroneous.
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