The Myth Of Purely Passive Investing

July 11, 2017

[This article appears in our August 2017 issue of ETF Report.]

“Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking and all the children are above average.” For decades, Garrison Keillor introduced the news from Lake Wobegon on “A Prairie Home Companion” with those words. We all chuckle when we hear them, mostly because they ring so true. After all, have you ever met a parent who described their kids as “below average?”

This is, in the end, the ultimate reason active investing is never going to go the way of the dodo. I know this from personal experience—I used to run an active mutual fund back during the dot-com boom. I like to tell the joke that “I was an active manager, but I got better.”

The pull to at least try to outperform is real. We all know the math, of course. As a class, investor experience must equal the performance of the market-cap-weighted benchmark of a given investment universe minus expenses. It’s a message that index proponents have been preaching for decades, and it’s taken hold of the investor zeitgeist, resulting in a near-trillion-dollar shift from active to passive since the financial crisis.

It Lives!

But active management is alive and well, and will continue to be, because there’s a huge part of the population that has a hard time settling for average. On paper, we invest just for returns. In reality, we also invest for psychological reasons.

Buying a lottery ticket is always a poor financial decision, but then again, so is going on vacation or buying a novel. Investors make imperfect, and occasionally noneconomic, decisions all the time. It doesn’t make them wrong—except in the strictest mathematical sense.

More to the point, I don’t know a single investor who actually holds the market portfolio of all available securities. I know that I don’t. Instead, even the most passive investor makes decisions about, e.g., what percentage to have in stocks or bonds, how much international exposure to have and whether to include commodities and real estate.

 

Even if they outsource the decision-making to a robo advisor, the decisions are still being made. They may be assisted by the shiny rearview mirror of modern portfolio theory, but they’re still decisions—active decisions.

Active Just Happens
Every investment decision is a form of active management. I’m always amused that people think buying the S&P 500 is a passive choice. Nothing could be further from the truth.

Using the S&P 500 as your U.S. equity exposure means deciding you want cap weighting, and that you want your large-cap exposure tempered by about 10% midcaps. You’ve decided not to invest in small-cap stocks. You’ve decided to have a committee decide what stocks are in or out. There are significantly different decisions you could make: You could buy a total-market ETF, an equal-weighted ETF, a pure-large-cap ETF, etc. And that’s just one slice of a portfolio.

How you choose to invest—or what you recommend to your advisory clients—is of course up to you. But I think even the most self-professed passive, index-focused, low-cost ETF investor would do well to recognize that, really, we’re active investors too. We’ve just shifted the source of the active decision-making from a portfolio manager to ourselves. 

 

 

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