Passive Investing Doesn’t Exist, But So What?
I wrote the book, The Power of Passive Investing, so you’d expect me to be the last person to say there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist. Passive investors shouldn’t let this get in their way.
Every mutual fund has turnover and every portfolio of funds has turnover. Active funds turnover securities in an attempt to beat a market and index funds turnover securities in an attempt to track a market. Every investor’s portfolio also has turnover. Money is coming in and out that needs to be invested. This included contributions and withdrawals, as well as dividends.
Index construction methodology has rules for inclusion and exclusion and index constituents change often. There are buyouts, mergers, and other types of corporate actions; interest and dividends are paid and need to be dealt with; and then new issues come to market and decisions are made when to include these securities. All of these factors, plus many more, confront the index fund manager.
Investors have their own active decisions to deal with. There’s an asset allocation decision, index fund and ETF selection decisions; cash flows in and out of a portfolio; rebalancing is often part of the strategy to control risk; and so forth. Net, net — there’s a lot going on even in passive investment strategies.
At first, I didn’t accept the idea that indexing was an active activity. Why would anyone think such a thing? John Bogle certainly didn’t. The very idea that indexing is active management is heresy.
Steven Schoenfeld changed my mind on this subject about 10 years ago. He is the author of the classic book Active Index Investing [Wiley, 2004] and a well-respected former index fund manager.
Schoenfeld explains in his book that index funds are not indexes. They are portfolios that must be continuously maintained by real people who face difficult issues when trying to track an index. The managers must make hundreds of active decisions each day concerning when to trade, what to trade, what to do with new cash, how to raise cash when needed, whether to use futures, swaps or other derivatives, etc. There’s nothing passive about managing an index fund.
They were excellent points. Trading, by its nature, is active management and index fund managers did a lot of trading just to stay in the game.
I then began thinking of my own business as an investment adviser. My strategy included mostly index funds and ETFs in a diversified portfolio for clients based on their long-term needs. It was a passive strategy, yet I made countless active decisions in portfolios pursuant to this passive approach.
A client sends cash into an account for investment — which asset class should be bought, how much should be bought, should I buy one fund or several funds in each asset class, should the money be invested all at once or dollar-cost-averaged?
Fund selection was another issue. Which indexes did the funds track, was there overlap among funds, should a traditional fund be used or an ETF, what where the expenses, what were the trading costs?
Rebalancing raised many more questions. Should rebalancing be done and if so when (at year end, quarter end, during the month when needed)? Should all asset classes be rebalanced or just the ones off by the most? How do taxes play into rebalancing?
Thousands of active decisions need to be made by a passive index fund adviser. Some of these decisions have large consequences on portfolio returns and taxes.
“Oh great,” I thought, “I’m an active manager now. Just the thing I didn’t want to be.”
Then I realized, it’s not the actual process of portfolio management that determines if a strategy is passive or active; it’s the goal of the strategy that makes the difference.
A passive strategy attempts to track the market(s), even though it’s understood that market indexes are active themselves. It’s a passive strategy when an index mutual fund’s goal is to track the performance of a benchmark. It’s also passive when an investor selects a fixed allocation to low cost index funds and ETFs and trades these funds to closely maintain the target allocation.
In contrast, an active strategy exists when a fund manager knowingly and willingly attempts to beat a pre-designated benchmark. It’s also active management when an investor or adviser attempts to beat a blended benchmark of appropriately selected indexes. The success or failure of active strategy is always measured on a net-of-cost, risk-adjusted basis against its benchmark.
Pure passive investing does not exist, but that shouldn’t matter to passive investors. When the goal is to be the market rather than beat the market, that’s passive in my book.
Indexes used in passive portfolios and for active management benchmarking should be broadly diversified and free-float capitalization weighted. This methodology represents the universe of securities that all investors have access to. This is “the market.” There’s no other way to accurately measure or describe the investable market for securities.
In my next article, I’ll discuss how “strategy” index funds differ from market benchmarks and whether “tilting” a portfolio to a stylized index is an active or passive strategy.