Swedroe: How To Define Passive Investment

Recently, I heard Nobel Prize-winner and finance professor Eugene Fama define “active management” as any fund that engages in security selection and/or market timing. And actively managed funds are fairly easy to identify. As we know, the term “passively managed” is used to describe the opposite of actively managed. But what, exactly, is meant by passively managed?

Given that there’s so much discussion surrounding this subject, I thought it worthwhile to describe how I answer that question. We’ll first provide my requirements for a fund to be considered passive. Then we’ll discuss some additional criteria you should use before you consider investing in a passively managed fund.

We’ll begin by stating that once you make a decision to deviate from owning a total market fund, you are making an active decision, and you should have good reasons for making that choice. But it is possible to find and invest in a passively managed fund that isn’t also a total stock market fund.

For example, all index funds—whether they are small-cap, value, emerging markets, REITs and so on—are passively managed. A fund, however, doesn’t have to be an index fund to be considered passive. You could create a fund, for instance, that owned the 10 largest stocks by market capitalization and equal-weight the holdings (versus market-cap weight), then use cash flows to rebalance and maintain that equal weighting.

Such a fund would clearly be passive according to our definition, because there is neither any stock selection nor any market timing occurring. So what qualifies a fund to be categorized as passively managed? Here are my two requirements:

1. Transparency: The fund’s portfolio construction rules must be well-defined and transparent.
2. Systematic Implementation: The fund must implement the strategy (construction rules) in a systematic and mechanistic manner. The processes must be rules-based and applied in a disciplined way.

These two requirements are intended to provide investors with confidence that results are replicable and repeatable. However, while these two characteristics would be sufficient to qualify a fund as passively managed, they aren’t sufficient to justify an investment. There are six additional criteria.

A Deeper Dive

It’s important to note here that the definition of “passive” shouldn’t include a requirement for low turnover. A good example is the DFA Two-Year Global Fixed-Income Fund (DFGFX) from Dimensional Fund Advisors. (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) The fund is passively managed, yet Morningstar reports it has turnover of 123 percent. Another example involves momentum strategies, which can be passive, yet have high turnover.

1. Evidenced-Based: The fund’s construction rules should be based on evidence that is both persistent (across economic regimes and time) and pervasive (across geographic regimes, developed and emerging markets, and, where applicable, across asset classes). There is strong evidence, for example, that the momentum factor meets all of these requirements. It exists not only in stocks, but also in bonds, currencies and commodities. That provides investors with the necessary confidence that the historical premium isn’t just a result of data mining.
2. Unique Character: The strategy provides access to unique sources of returns that diversify the risks of the overall portfolio. These sources of returns should exhibit a low correlation to the portfolio’s other assets.
3. Economic or Behavioral Explanations: There should be strong, and well-reasoned, economic or behavioral support for a strategy. The strongest support would be a logical, risk-based explanation for a premium to exist. However, if there’s a well-documented behavioral explanation, that too can provide the rationale for investing. This is especially pertinent if there are limits to arbitrage (for example, many institutional investors are prohibited from shorting or using margin) and other constraints (transaction costs and fear of margin, for instance) that prevent the market from correcting “mispricings.” This is likely to occur with less liquid stocks, where trading costs can be high.
4. Minimization of Idiosyncratic Risks: A fund should seek to reduce idiosyncratic risks to a very low level. The market doesn’t reward investors with premiums for taking idiosyncratic risks, or those risks that can easily be diversified away. Thus, a fund should be broadly diversified in its exposure to the factors or asset classes in which it invests.
5. Implementable Strategy: The returns can be captured by trading liquid instruments with low trading costs. This becomes particularly critical for strategies that require higher turnover.
6. Proven Experience: The fund family should have the proven ability to manage assets in a similar strategy. This is especially important if the strategy has high turnover and/or the securities in the portfolio are less liquid, like with micro-cap stocks, where the bid/offer spreads can be wide.

Passive Can Seem Like Active

A good example of a fund that many would consider active, yet meets all of the above criteria, is AQR’s Style Premia Alternative Fund (QSPIX). This fund invests in a manner that once was limited to the hedge fund world. It is a long/short fund that invests across four styles: value, momentum, defensive and carry.

The fund’s strategy is transparent. That strategy is implemented in both a systematic and mechanistic manner. The strategy’s four styles are well-documented in the literature. The premiums are persistent and pervasive. Each style has a strong economic or behavioral explanation.

These strategies are implemented through liquid securities and are well-diversified. And each style exhibits low or negative correlation with the other three styles, and with beta as well. Thus, it meets all the tests both for being passive and for being considered for investment.

A Word About EMT

There’s one more issue we need to discuss. If you search the Internet for a definition of “passive investing,” you are liable to find something like the following from Investopedia: “Followers of passive management believe in the efficient market hypothesis. It states that at all times markets incorporate and reflect all information, rendering individual stock picking futile. As a result, the best investing strategy is to invest in index funds.”

But passive investing doesn’t require a belief in market efficiency, or the use of index funds. After all, the greatest challenge to the efficient market hypothesis is the existence of momentum in prices, which most consider a purely behavioral phenomenon. And if we use professor Fama’s definition of passive, we find many passively managed funds that incorporate momentum strategies.

What Matters

In summary, while the debate about what is active and what is passive might be an interesting (and sometimes amusing) one, in the end, it really doesn’t matter.

People can find themselves fighting over issues that amount to nothing more than an issue of semantics. However, what really does matter in the end is whether you’re getting an investment that adds value to your portfolio by meeting the conditions set out above.

If that’s the case, the definitions and terminology become irrelevant. What remains relevant is if you are paying a fair fee for the value received.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.