It's Time To Eliminate The Term 'Passive' Investing

by: Cullen Roche

John Rekenthaler of Morningstar wrote a good piece Monday 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, 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.