It's All Active

July 01, 2018

[This article appears in our July 2018 issue of ETF Report.]

If there’s one topic guaranteed to fire up commentators on CNBC, it’s the role of index investing in our modern markets. Depending on the guest, indexing is either the very best thing that’s ever happened for investors, or it’s a cancer that will destroy global capitalism.

The key argument of the cancer squad tends to go something like this: If everyone in the world only invested in indexes, there’d be no price discovery, and the best and worst companies would rise and fall equally. It’s for this reason that a Bernstein report two years ago called passive investing worse than Marxism. (A least in Marxism, someone is allocating capital based on some reason!)

There’s a core problem with this: We’re all active investors.

Impossible Passive Portfolio
To truly be a passive investor, we’d all have to have portfolios that perfectly mimicked the global allocation of capital into investment securities. Our global stock exposure would be a single fund—say, the Vanguard Total World Stock ETF (VT). We’d hold that in perfect proportion to all of the bonds in the world, and perhaps all of the real estate and commodity production, and then perfectly hedge it to remove any impact from currency movement.

There’s not a single investor in the world who owns that portfolio. Instead, we all have unique, personalized portfolios that reflect our own biases, personal situations, acumen and—if we’re being honest—incompetence. Some of these decisions are honestly accidental: I have friends who’ve forgotten to change their 401(k) allocations for 10 years, making them ever-more invested in large-cap U.S. equities. I have relatives who’ve overinvested in company stock, or left their IRAs in cash for years.

Whether these are good decisions, or even intentional ones, they’re fundamentally active management decisions. Every decision to hold anything but that unowned total market portfolio is an active management decision. Of course, more intentional market participants—yes, even ETF investors—make much more meaningful active management decisions.

While it’s true that the lion’s share of ETF flows have gone into low-cost vanilla products, they have not all gone into VT. For example, in April, international and emerging market ETFs had big inflows. In May, much of that reversed. Taken as a whole, those are active management decisions being made that resulted in underlying stocks being bought and sold.

Fund by fund, these flows in and out of factors, sectors, strategies, asset classes and even flavor-of-the-month themes are the engine of price discovery the naysayers are worried will stop working. If anything, ETFs have made it even easier to make those kinds of active bets than the traditional index mutual fund did.

So, fear not: Like it or not, we’re all active investors.


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