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“The Passive/Active Distinction is About Cost”

I really liked this interview with Joel Dickson of Vanguard.  In the interview he cuts to the chase on the active vs passive debate:

“The active/passive distinction is really more about costs than it is about the intelligence or the randomness of active management.  It is about costs”

I keep harping on this point because I think it’s very important to understand the asset allocation process.  The idea of “passive indexing” serves no purpose other than to create a distinction where there really is none.  That is, a buy and hold asset allocator who picks 500 large cap stocks to own is not doing anything all that different from the buy and hold asset allocator who buys the SPY S&P 500 ETF, IF HIS/HER COSTS ARE THE SAME.  But “passive indexers” would like you to believe that the stock picker is doing something distinctly different as if they are necessarily “active” just because they picked stocks.  This distinction is totally meaningless.  These two asset allocators are doing the exact same thing if they can construct their holdings in the same cost efficient manner (which, by the way, is precisely what firms like WealthFront are starting to do by owning the S&P 500 in its entirety).

So, this debate really comes down to costs.  John Bogle’s “Cost Matters Hypothesis” is the key lesson here.  But I think the “passive indexing” community got a bit overzealous in their demonization of “active” managers over the last few decades and didn’t fully realize that they were also picking assets inside the global aggregate.  Indeed, ALL INDEXERS ARE ASSET PICKERS who are just slicing up the global aggregate index in varying ways.  The difference between smart asset allocators and stupid ones is that the smart ones are fully aware of how much fees, frictions, behavior, etc hurt their long-term returns.  Still, none of this should trump the “Allocation Matters Most Hypothesis”.  That is, your active decision on how you allocate your portfolio over the course of your life will, by a wide margin, trump the “Cost Matters Hypothesis”.  So yes, we should be worried about costs, but not at the detriment of understanding the asset allocation process.


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    I’d really like to hear John Dachsbach’s take on this matter…paging Mr. Dachsbach…

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    Cullen, hat tip to you for being at the tip of the spear on this ridiculous “passive vs. active” debate. I suspect once the next bear hits and once we are deep into the next long, drawn out sideways market that the shine will come off the passive approach. I have little doubt that low cost choices are here to stay, but the passive approach will one day be under attack, just like 08/09. Rinse, lather, repeat. I don’t think, “I am down 40% but at least it is not costing me anything” will sooth too many folks.

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    The advantage of indexing is partly about cost; not just the expense ratio but the frugal mindset that may permeate the fund manager’s decision-making.

    But it’s also about close-to-market performance; close-to-market dividend yield; limited trading; total trade / position transparency, elimination of emotion, pseudo-science, risk-taking and hubris from the decision process; and having the ability to examine the track record of the index in question and make reasonable judgments about expected long-term future performance.

    While I acknowledge indexers still must actively allocate, I believe all of these are meaningful advantages for the indexable components of one’s portfolio.

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    John Daschbach

    Technically I suppose it’s Dr. Dashbach, but I prefer John.

    I can’t think of any way in which Cullen is not correct about this. In the limit everyone’s excess income (savings) is allocated proportionately to the Global Financial Asset Portfolio (or whatever you want to call it). That is the only equilibrium solution and thus the only truly passive allocation. But, as Cullen notes, it doesn’t exist.

    Index funds probably reduce what economists often call “frictions”. In this case it’s between asset classes and at a finer level between individual assets. An index fund averages over the finer level with a computer algorithm but that’s an arbitrary distinction.

    Asset managers, like Cullen, hold peoples hands. They like this and Cullen likes this. He thinks about things that his clients don’t think about, and they pay him for that. They should. What is that worth? That is very hard to put a number on.

    I don’t know the number. My estimates are that it’s worth at least 0.1% of assets under management and probably not more than 0.5% of assets under management. 0.25% perhaps? That’s an income to Cullen of $250K per $100 million under management. Five to twenty clients. Sounds pretty good. Perhaps 0.1% is the better number.

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    Cullen Roche

    A good asset manager does more than “hold hands”. He/she profiles clients so that they understand risk and then applies a thoughtful allocation to that client and maintains it over the course of the business cycle. I don’t manage cookie cutter portfolios for people. I manage assets the same way I manage my own assets – with the understanding that markets are dynamic and not always in equilibrium. So there is some cyclicality to a good portfolio although I am far from an “active” investor.

    I think you’re confusing what I do with what a “passive indexing” asset manager does. I have no idea why anyone would pay an asset manager to “manage” a static index fund portfolio. You’re literally just giving away money then….

    Now, some people can piece all of this puzzle together on their own. Others are more comfortable reaching out to a professional. There probably aren’t very many professionals I’d invest my money with though….

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    Cullen Roche

    My beef with indexers is that they don’t seem to understand what they’re doing. Take a risk parity portfolio run by AQR which just picks a set of assets and leverages the fixed income piece relative to Vanguard Wellesley Index Fund. What is different about these portfolios? At first blush, not a whole lot. They’re both fixed income heavy portfolios, buy and hold assets, diverse, etc. Both choose an asset allocation that deviates from the global cap weighted index….They’re both active in that sense, but the “passive indexers” would likely tell you that the Risk Parity fund is “active” or something because they don’t understand that all of Vanguard’s funds are deviations from global cap weighting, ie, all of Vanguard’s funds are actually active funds. It’s a totally misleading distinction.

    The difference between the two funds is that you’re paying a much higher fee in the AQR Risk Parity portfolio because the portfolio is more dynamic. Does it pay off? Well, that depends. I’d say the fees are probably still too high, but if you could implement the Risk Parity strategy for a fee that was closer to VW’s 0.26% then it would be a no-brainer to own it. Who cares if it’s “active” or “passive”. It diversifies your portfolio through strategic diversification in much the same way that Vanguard Wellesley does except it’s probably a better fund with the same fee structure….

    So what we see is that this isn’t really about “passive” and “active” at all. That’s just marketing jargon used by people who don’t know what they’re actually doing. It’s really all about fees. High fees suck. No doubt. But the passive indexing community has tried to differentiate themselves from all asset allocators without realizing that their approaches are all active asset allocation approaches as well….

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    Everyone with assets is an asset allocator. Some are largely set and forget which is the passive end of the spectrum of asset allocators, some are rebalance to their original allocation every quarter so are still relatively passive, some are day traders and so are at the extreme end of active investors.

    I agree that we are all asset allocators even down to a decision about buying a car or an SUV or keeping the cash and paying for taxis, but some are extremely active in changing their allocation and do it at the company level, while others adopt a broad portfolio approach and don’t change it (ie ignoring the changes wrought by changes in asset values) very often and so are passive.

    Active and passive are about frequency of activity, not about denying that there is allocation of assets.

    I agree that it is partially driven by costs, but it is also partly driven by having rules one can abide by during dramatic chnages in the market, thereby overcoming extremes of human emotions.

    Remember that even in funds with excellent performance, the individuals often sell out at the worst time and so have far inferior performance to the fund they initially invested in.

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    Is this really even a debate, though? It seems like anyone that knows anything about buying assets understands that index funds are implicit long bets on equities, and therefore are “active” choices that equities will outperform other asset classes.
    Am I missing something?

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    Cullen Roche

    I guess that’s the question – do people really understand that? From my interaction with BogleHeads they fully reject the idea that they’re making a forecast about the future at all…

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    I think the most important thing here is that we’ve successfully identified a group of people that can easily be ripped off if you can play to their biases correctly…

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    Cullen Roche

    That’s a big part of what got me onto this “active vs passive” kick. When I realized that we all deviate from global cap weighting I realized that the distinction was a sales pitch. Ie, “passive indexing” was just a branding technique used by some firms to differentiate themselves from stock pickers. I guess they never realized that they’re asset pickers. And many of these firms like DFA (whose founder is a Chicago School economist, barf) or other “passive indexing” firms charge pretty high fees for their portfolios. But people gobble them up because they think they’re getting a good deal because “passive indexing” is supposed to be better. People don’t actually understand that it’s really just a different form of asset picking inside the aggregate.

    As I audit more and more RIAs I find this problem is incredibly pervasive in my reviews. So many of my clients are paying 1%+ to a “manager” to oversee a portfolio of index funds. And the RIA isn’t doing anything! They’re literally buying and holding a portfolio of index funds for the client. I don’t get it. Why would anyone pay a “manager” for a static index fund portfolio? The only time you should pay a money manager a modestly high fee is when they’re providing you with something you can’t otherwise replicate on your own through a valuable strategically diversified portfolio….So yes, a lot of these people who buy into “passive indexing” appear ripe to be ripped off. Passive has become the new sales pitch for charging high fees for doing nothing. It’s not okay.

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    John Daschbach

    I said you think about things your clients don’t, or don’t want to, and you get paid for that. It is how it should be.

    But there is a significant component of hand holding since you, or anyone else, can’t put real quantitative numbers on risk. I think people intuitively understand that it’s not possible to estimate the tail risks in financial assets. So in the face of this uncertainty it’s a comfort to have someone else help make decisions, even if those decisions are based upon an analysis which necessarily does not include tail risks. If a tail event happens people want the comfort of having had someone else make the decisions. Lowering costs and reducing risk in non-tail situations is also worth something. I suspect however that the larger component is being able to have some ability to not blame one’s self in the event of a negative tail event.

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    “Passive vs Active” really is “Less Active vs More Active”. But more active methods do not guarantee to have better returns than less active methods. Reversely it is also true. It seems that the effects of active assets allocation methods are hard to link to asset returns.

    Thus, my question is: what is the right cost structure for charging clients? Should it have levels of costs charging structure? For instance, low flat fee for a static index management effect at first level. At second level, the cost should be based on return results not effects.

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    Mike Dever

    First, a “passive” fund follows an index, and an index follows a methodology. As I point out in my book, most of the index methodologies are naive, often discretionary, and instead of being focused on maximizing returns, often strive to be merely “representative.” If you believe in the passive argument, then by all means implement it, but do so systematically and follow a methodology designed to maximize returns, not just be representative. I discuss this in the 4th chapter of my book (which was the #1 best-selling mutual fund book on the kindle for more than a year).

    Second, the reason passive appears better than active is that every study I’ve seen starts by restricting their analysis to including just a few “asset classes.” If you start with such a constrained sub-set of the potential investment opportunities you will naturally end up with the conclusion that portfolios should be constructed of low-cost passive funds. So the problem isn’t with the analysis, it’s with the framing of the question. The reason passive is better in these studies is because when you are trying to capture just a single return driver, the best way to do so is to do so in the least expensive manner possible. As I point out in the opening chapter of my book, the return from owning stocks is dependent on a single dominant return driver. So yes, go with a “passive” fund to most efficiently capture this return driver.

    But if you want to attain the benefits of true portfolio diversification you need to diversify across multiple return drivers. Unfortunately you can’t do that using passive funds, for the simple reason that passive funds only employ public domain return drivers. And the best return drivers are NOT in the public domain. These return drivers produce returns that are completely uncorrelated with the ‘known’ return drivers. Just as you’d pay up for an Apple phone as opposed to a more generic mobile phone, you need to pay up to access the unique (non-public domain) return drivers.

    None of the “studies” on passive vs. active investing that I’ve seen and read over the years appear to understand this, primarily because they focus on asset class investing and fail to acknowledge the existence, let alone the importance, of return drivers.

    I’d be happy to provide any interested readers with links to the relevant sections in my book that cover this topic. I’d do that here but don’t want to be ‘commercial’ (even if I’m giving it away for free!). Send me a note and I’ll send you the links.

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