What Do Passive Investors Really Mean By 'Passive Investing'?

by: Cullen Roche

The term “passive investing” is actually a misnomer in the manner that most index fund investors use it. The reason why is simple. There is, at the aggregate level, just one portfolio of all outstanding globally cap weighted financial assets. And as soon as you deviate from that global cap weighted portfolio in your asset allocation, you become an “active asset picker” who believes he/she can generate a better risk-adjusted return than that portfolio can. You are, in essence, making a discretionary portfolio decision as opposed to just “taking what the market gives you.” Okay, so the whole idea of “passive investing” is a bit misleading. If you look at this through the macro lens it becomes clear that we are all active asset pickers deviating from global cap weighting. So what do the “passive” investors really mean?

First, it’s nice to look at some of the history here because we can start to see why confusion over this terminology has persisted for so long. In The Intelligent Investor, Ben Graham wrote:

“In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.”

That’s pretty clear. To Graham the distinction is about security selection and trying to earn a premium over the market return. So, active managers are essentially stock pickers who try to “beat the market.” Of course, this was written long before there was an index for everything. Today, most of us don’t pick stocks. We pick an asset allocation by holding financial asset that already have a certain allocation to certain assets. We are still selecting securities of certain types. We just do it differently than one might have in Ben Graham’s day. So Graham’s definition is a bit dated.

What about Eugene Fama? Fama has stated that active management is any fund that engages in security selection or market timing. Okay, but anyone who deviates from global cap weighting is “selecting” their own securities inside of index funds. So it really comes down to timing. But this too gets messy. After all, indexers engage in all sorts of active endeavors and simply call it something else like “rebalancing,” “factor tilting” or “dollar cost averaging.” These are all discretionary timing based decisions about how to engage in the markets. They’re just not marketed as “active management” for whatever reason.

Okay, so it’s becoming even more obvious that the idea of “passive” investing is a bit messy. But that doesn’t mean the defenders of “passive investing” don’t have important points. In my view, they make many crucial distinctions about portfolio management that every investor should adhere to:

  • You shouldn’t try to “beat the market.” Yes, we all deviate from global cap weighting, but you should build a portfolio that’s right for you as opposed to benchmarking yourself relative to some index. In the aggregate, we all underperform the global cap weighted portfolio after taxes and fees so the “beat the market” mantra is an impossibly high hurdle to begin with.
  • You should keep your costs very low. Costs will destroy a much larger portion of your portfolio than you likely think. In general, my rule is never invest in funds or with managers who charge more than 0.5%.
  • Keep your activity low. The more active you are, the more you’ll increase your tax burden. Like fees, taxes will crush you in the long-run.
  • Pick whole asset classes rather than individual securities. This reduces your risk and allows you to take advantage of diversification.
  • Create a plan that has staying power so you avoid tinkering with your portfolio regularly or letting yourself get in the way.

That’s it. This really isn’t about “activity.” After all, we are all active by necessity. But we can be smart active investors. And that’s the key to understanding the distinction between what people call “active” investors and “passive” investors.