By Cullen Roche
I've been on a bit of a kick in recent days talking about portfolio construction and some of the underpinnings that drive certain approaches. It's important to understand the underlying framework that drives a certain portfolio construction process because it is this framework that will ultimately increase or decrease the probability that you will be successful. Let's look at a few examples to better understand this point.
Passive indexing is a framework that derives largely from Modern Portfolio Theory and the Efficient Market Hypothesis which focuses on the importance of diversification, fee reduction and achieving the optimal amount of return given a certain degree of "risk". Passive indexers generally apply the Efficient Fronter to a portfolio to determine how best to diversify among certain asset classes. This approach rejects the idea of stock picking and emphasizes the importance of just trying to capture the "market" return in the most fee and tax efficient manner possible.
The asset classes involved in this approach can vary, but are generally comprised of a stock and bond mix. So, you determine your risk tolerance, apply the efficient frontier and then you allocate assets in a specific manner. For instance, a 40 year old with a moderate risk tolerance might utilize this approach to build a 60/40 blend of stocks and bonds in his/her portfolio.
While adherents of "passive indexing" often claim to be "passive" and "forecast free" what's really going on here is highly theoretical and highly predictive, however. Let me explain:
- MPT and EMH use standard deviation as risk. Therefore, when you find your spot on the efficient frontier with which to allocate assets you are, by definition, constructing a portfolio that is stock heavy in most cases. That is, the variance in a a stock/bond portfolio is highly likely to be driven primarily by the stock portion of the portfolio.
- A general 60/40 stock/bond portfolio is not actually a 60/40 portfolio because the portfolio is over 80% correlated to the broader stock market.
- Given that most of us have a fairly long time horizon this approach is likely to result in a portfolio in which the variance of the underlying performance is determined primarily by the stock component. As a result, most "passive indexing" portfolios are largely bets on the stock market.
A few thoughts there - this is all fine and dandy. The stock market tends to do well over long periods of time because the output of the underlying corporations tends to be positive as we stretch the periods out longer and longer. Betting against human innovation is just about one of the worst bets you can make in life. But we should also be clear about a few things here:
- Passive indexers are using an underlying framework that essentially overweights the probability of rising stock prices over the long-term and therefore makes an implicit macroeconomic bullish forecast.
- The framework uses standard deviation as "risk" which is not applicable to the way most investors actually perceive financial risk which means that the portfolio outputs might not be appropriate for many investors.
- Passive indexers are, by necessity, quite active because this approach requires rebalancing, dollar cost averaging and other somewhat "active" portfolio management.
Are There Alternative Approaches?
I take a different approach in my book Pragmatic Capitalism, but I don't have have the space or time to go into all of that here so I'll use a widely known example. Of course, there are lots of different alternatives to a passive indexing approach. A value stock picker might reject a macro perspective like the passive asset allocation approach and instead focus on choosing individual stocks based on calculations of intrinsic value or any other number of approaches. But let's stick to asset allocation approaches here just to remain consistent and communicate the point more clearly.
A popular strategy that is also an asset allocation approach widely considered to be "passive" is Harry Browne's Permanent Portfolio. Browne's underlying framework is very different from the one described above though. Like indexers, Browne believed that it was impossible to predict the direction of the markets and the economy. But he didn't take a stock heavy approach that was derived from the use of MPT and the Efficient Fronter. Instead, he simplified matters thinking of the economy as four distinct potential environments:
He said there was no use trying to predict the economic "weather" so you were better off applying an underlying approach that accounted for all of these environments (hence, an "all weather" approach). So he applied assets that would perform well in each environment as such:
- Inflation - Gold
- Deflation - Government Bonds
- Expansion - Stock
- Recession - Cash/Bills
Now, there are many ways to slice that up and create variations of it, but the general framework was simple. The problem with this portfolio is that it's not all that easy to replicate perfectly and the funds that do it charge fees that are a bit higher than a purely passive approach like a 60/40 (PRPFX and PERM both have fees of ~0.5% or higher).
Also, the Permanent Portfolio will derive its performance from very different underlying drivers because the foundations upon which it is built are very different. I would argue that Browne was being more predictive than he might think (there are some explicit assumptions in the asset performance relative to certain environments). The point is that his framework creates a portfolio that will perform very differently from the 60/40 or other "passive" approaches.
The takeaway here is that these are both somewhat inactive approaches over time, but one is slightly more efficient because it doesn't require the added costs of the extra diversification. Whether that added diversification is a benefit that outweighs the fees is difficult to predict. Most importantly, there are all sorts of underlying assumptions, predictions and guesswork involved in these approaches. The fact that one is lower fee than the other doesn't necessarily make it better (unless fees are the only thing you care about!).
There are countless other ways that we can implement a portfolio and I've gone on way too long here, but the point is that it is extremely important to understand your underlying framework and how it's connected to other macro drivers, assumptions, theoretical underpinnings and implicit/explicit predictions. No one is a truly "passive" investor because there are implicit assumptions and theoretical foundations in any framework that drive the portfolio construction process. As regular readers know I am a stickler for seeing the world "as it is" and not "how I want it to be" so you should go into the portfolio construction process with your eyes wide open based on a sound understanding of the drivers that determine a portfolio's results. Hopefully this helps clarify things a bit for you.