Recently my friend Cullen wrote a piece titled “Putting the “Underperformance” of Active Managers in Perspective” that spurred a bit of discussion between the two of us. While Cullen and I may disagree to some degree about the benefit of a more “active” investment strategy (including how tactical one might be with a portfolio), one thing that we do agree on is that there is no truly 100% “passive” strategy, just as much as there is no long-term “forecast-free” investment strategy. Certainly many of us investment advisors, even those who profess to believe in “passive” investment strategies, are forced to make “active” decisions every day.
Personally I have come to believe that “passive” is a terrible misnomer. The reality is that every investor is making “active” decisions, including:
- Asset Allocation. Broadly, what % of your portfolio will be in stocks vs. bonds? What about US vs. foreign stocks? A truly “passive” approach would invest in the global market portfolio. But the global market portfolio is only about 37% in stocks, with the rest in bonds and other assets. A “passive” approach would have a US investor’s stock exposure over 50% outside of the United States but many advisors will recommend a “home bias” with a larger allocation to US stocks. An individual’s goals and desire to take risk forces us to make an “active” decision.
- Rebalancing. A truly “passive” approach would never rebalance a portfolio. You would simply buy the global asset portfolio and allow it to drift permanently with the gains and losses in the markets. So deciding to rebalance at all is an active decision. Then we also must decide how frequently we will rebalance and what tolerance levels around your target allocation you will allow. Then you must decide in which accounts you will rebalance and how you will manage the tax liability that rebalancing often triggers.
- Factor Exposure. There is long-held ample evidence that certain risk factors deliver additional return (and additional risk) when compared to a broad market index, such as the small-cap or value premium. As investors we are forced to decide if we will build our portfolios to overweight these risk premia in hopes of earning additional return, and we must decide to what extent we will do so. Will you invest in only the smallest and deepest value segments of the market or will you blend that exposure with a holding more representative of the total market? Will you seek out these additional premia in just US markets or also in foreign developed markets and emerging markets?
- Asset Location. If you are an investor with both taxable investments and tax-deferred retirement accounts, will you make different asset allocation decisions in each given the tax status? Will you own more stocks in one account and more bonds in the other? Do you understand the potential trade-offs you may make in the process, or the tax advantages of sheltering certain asset types? How will these asset location strategies affect your rebalancing process? How will they affect your income distribution strategy when needed?
- Index Selection. If you are an index investor, which index will you own? The S&P 500 in the US or the Russell 3000 or the Wilshire 5000 or a Total Market index? Internationally will you look to MSCI or FTSE or another index provider? How does the index composition affect your long-term returns? Where is the line between large cap and small cap? Developed economies and emerging? Growth and Value? What fees are built into the index product for licensing?
- Tax Loss Harvesting. Tax loss harvesting has been documented to add to investors’ after-tax returns (though calculations vary widely). If you plan to harvest tax losses, how frequently will you do so? How will you decide when the value of the loss overcomes the trading costs? Will you move to a new permanent position in the portfolio (thus slightly altering the exposure) or return to your original position after waiting 31 days, potentially triggering additional trading costs and capital gains? Which products will you substitute for your current holdings?
- Product Provider. If you are a “passive” investor using index mutual funds and ETFs, which company’s products will you use? Vanguard? iShares? DFA? Schwab? Rydex? ProShares? Powershares? Fidelity? Why?
It appears as if we aren’t so “passive” after all. While I believe there are tremendous gains to be had from moving away from expensive and tax-inefficient stock-picking and tactical asset allocation, we shouldn’t pretend that any investment strategy can function without hands-on decision making.
Rick Ferri: Confessions of an Index Investor