Active Versus Passive – Understanding the Debate Part 2: Passive Investing

In this next post, I’m going to focus on passive investments and passive investing. If it looks like I just repeated myself, I didn’t. Passive investments are much different than following a passive investment strategy for portfolio management. As a reminder, a passive investment is a style of management where a predetermined basket of securities are purchased and automatic adjustments are made with no personal judgment or forecasting.

Passive investment products and the indices they seek to track

I’ll assume that an investor has done their homework (read my first post!), and has decided to use passive investments in their portfolio. So, what to do now? The next step is to determine what products, and in turn market indices, are the best options for their portfolio, given the goals and broad long-term asset allocation of their account. At first blush, this should be a relatively simple exercise, right? Well, it depends. A quick examination of our third-party analytics database reveals over 40,000 global indices that are denominated in U.S. dollars. While only a small fraction of these indices are actually investable, meaning there is a product available to invest in that “tracks” the given index, it nonetheless demonstrates the extraordinary amount of “noise” an investor must navigate through in order to select individual products and build a final portfolio.

The data on the number of indices available in the preceding paragraph was not stated to exaggerate the issue. Instead, it was meant to illustrate that many questions will need to be answered prior to making a decision on what passive investment to choose. For example, even at a very basic level, if an individual simply wanted broad exposure to the domestic U.S. equity market, the individual would need to determine what passive investment and in turn, market index best suits their needs. Unfortunately, this seemingly easy task may elicit a variety of responses if that individual were to survey a group of investors regarding what index they believed constituted the broad U.S. equity market. Is it the S&P 500? The Russell 3000? The Wilshire 5000? The CRSP U.S. Total Market Index? All of these indices are very different from one another. And as an individual moves to foreign equity markets, it becomes even murkier. Does, or should, the total foreign market index include emerging markets, or just developed markets? How does the index provider classify emerging vs. developed market countries (they vary by index provider)? In domestic and foreign markets, do the indices include small- and mid-capitalization stocks?

Furthermore, if an investor determines they would like to move beyond broad market products and instead use a greater number of passive investments in a portfolio by targeting specific market capitalizations, styles, factors, regions, etc., they will significantly increase the number of choices that are available. Consider broad small-cap equity products – even after making the decision to invest in small-cap stocks separately from a broad market equity product, there are still more choices. For instance, the definition of “small-cap” is different across index providers including Russell (Russell 2000 Index), S&P (S&P 600 Index) and CRSP (CRSP U.S. Small Cap Index), to name a few. Depending on the index chosen, an investor can wind up with very different exposures and very different results, especially over short- to intermediate-term timeframes. The issue with using more products in a portfolio is that an increased number of options may also increase the possibility that the final, total portfolio is not constructed in an optimal fashion.

What is passive investing?
So far, I have only discussed “passive” as it relates to individual investment products. Passive investing refers to how the investor manages the combination of all individual products at the total portfolio level. This is the point where I believe the “active vs. passive” debate has not provided investors with enough information.

In instances where an investor has hired a financial professional, the investor needs to determine whether or not the strategy implemented by that individual is “active” or “passive.” Understanding how your advisor manages your portfolio is just as important, or more so, as understanding the types of individual investments chosen for your portfolio. But, before I dive into this topic more, some background on my views of passive investing (also referred to as a “passive strategy” in the remainder of this post).

In my opinion, a “true” passive strategy at the total portfolio level is meant to be buy and hold (“buy and hold” means that an investment is purchased and held for the long-term), with only periodic rebalancing of the portfolio to long-term target weights that are reflected in an investor’s investment policy statement; the road map for investing your portfolio over the long term. Additionally, I believe that a “true” passive strategy should only use passive investments that mirror broad market indices. This is because a true passive strategy is simply looking to attain broad market exposure in the most cost-conscious manner possible without incorporating anyone’s views of the market into the portfolio construction process. This means that after the broad asset allocation has been determined and reflected in an investor’s investment policy statement, and the broad market passive investments have been selected to fill the client’s asset allocation, there are no further “active” decisions that need to be made.

In my opinion, what a passive strategy is not meant to be is: 1) actively trading passive investments in a portfolio; and 2) investing in subsets of the broad market regardless of whether or not the vehicle used is a passive investment product. If either of these actions is taken in a portfolio, the individual responsible for managing the portfolio is actually following an active portfolio management strategy – deciding which assets to include or not include in a portfolio. These are “active” decisions.

An Example
Consider the example below. Is this portfolio, which is built using passive products, following a passive investment strategy?

  • 40% Russell 1000 Growth Index ETF
  • 15% Russell 2000 Value Index ETF
  • 15% Russell Mid-Cap Core ETF
  • 30% MSCI EAFE ETF

While some may view this portfolio as “passive” because it only invests in passive investment products, in my view it is not. This portfolio will demonstrate relatively high tracking error (i.e. perform differently) to the entire global market, both in domestic markets and foreign markets, because the portfolio only includes subsets of the domestic and foreign equity markets. For instance, the portfolio has a relatively large tilt to growth stocks among larger cap domestic companies, a tilt towards value stocks among smaller cap domestic companies and has no direct exposure to emerging market equities.

In the event that a portfolio is constructed in this manner, numerous questions must be answered and answered well. For example, if the advisor does not believe in active management because they do not have confidence that active investment products can add value, then why do they think they can add value through actively managing (trading) passively managed products? Does the individual making these decisions have research to back up their “active” decisions to only invest in a subset of the total market? Are these individuals timing the market? Are they making calls on growth vs. value? Are they making calls on market-cap? Are they making calls on specific factors (quality, momentum, etc.)? Are they making calls on specific countries, regions, sectors, industries, etc.? If they are doing any of these things, what makes them qualified to do so? What is their track record? What is the expected performance benefit? Historically, has the value add been greater than the trading costs associated with making the trades? Do they receive commissions for these trades? If they can’t demonstrate value-add from the trades and those trades are generating additional fees, then why do they do the trades?

This line of questioning is not meant to be hostile; rather it is to educate you as an investor, and a fee paying client, so that you fully understand how a fiduciary is managing your capital.

Similar to the active/passive debate for individual products, undoubtedly there are talented advisors that do a superb job at managing portfolios. And more often than not, successful advisors will be more than happy (and very willing) to share their investment philosophy, investment process and results. However, there are individuals that are actively (tactically) managing client portfolios, with or without passive investments, that are damaging the long-term return potential of those portfolios (by incurring additional fees from making the trades, not being particularly adept at making tactical decisions, etc.). Again, this is an exercise in understanding what you do know, understanding what you don’t know and then forming an investment strategy around those strengths.

The key takeaway from this post is that there are questions that individuals need to ask the individual they hired to manage their portfolio even if that individual is using so-called “passive” investments. True passive management can be a very good strategy, if the right investment products are used and the individual managing the portfolio follows a passive investment approach. However, I am apprehensive about the promotion of passive investments as the only solution for many investors, particularly when the products being promoted are not passive products that represent the broad market, and are not being utilized by an advisor that follows a passive approach to portfolio management. This is unfortunate because some financial professionals may tout the benefits of passive investments, yet because they follow an active investment strategy, they may dilute, or nearly eliminate, a number of the main benefits of utilizing passive investments in the first place.

In my next post – Part 3, I’ll explore active investments, active investing as it relates to total portfolio management, the selection of active managers and the role of various measures such as “active share” in understanding how managers can add value.

Charles J. Batchelor is Director of Investment Research for Cleary Gull

© Cleary Gull