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We’re All Active

Phil Kernen

OVER THE PAST TWO decades, investors have increasingly shunned actively managed mutual funds, instead embracing index mutual funds and exchange-traded index funds. This has led to a contrived debate over whether active or passive investing is better.

My contention: It’s wrong to position indexing as somehow the mirror opposite of active management. Why? Even if you eliminate active mutual fund managers and their fees from your portfolio, you still need to grapple with three crucial investment decisions—all of which involve the sort of judgment call active investors must make.

1. What asset classes do you want to own? Research shows that asset allocation—your portfolio’s basic split between stocks, bonds and other asset classes—is the key decision in driving your investment returns and how likely you are to reach your financial goals.

Think about the past decade. If you look year by year, the top-performing asset classes have included inflation-indexed Treasury bonds (2011), emerging markets (2012 and 2017), small-cap stocks (2013 and 2016), real estate investment trusts (2014 and 2015), cash investments (2018) and large-cap U.S. stocks (2019 and 2020). There’s been plenty of turmoil in these different parts of the market and plenty of uncertainty about which asset classes will shine.

You—or your financial advisor—must decide how you want to allocate your money among these and other investment options. There’s no obviously right way to do this. Still, you need to make a decision—one that inevitably involves a judgment call.

2. Which investments will you use? Passive strategies have been around ever since Vanguard Group introduced the first index mutual fund in 1976. But the boom in passive investing over the past two decades has been driven by a different sort of index fund, those listed on the stock market. There are now more than 2,200 exchange-traded index funds (ETFs), according to Investment Company Institute data for December 2020. If you decide to build your desired portfolio using ETFs, you’ll need to choose from among 1,032 U.S. stock funds, 637 global stock funds, 413 bond funds, and 122 hybrid and commodity funds.

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If you want large-cap U.S. stock exposure, should you buy a fund that mimics the S&P 500 or the Russell 1,000? Benchmarks such as these are largely rules-based portfolios. If they meet the rule, the security will most likely be added to the index. Some of the benchmarks are better known than others, but that doesn’t mean they’re a better choice.

To be competitive and stand out, many ETF sponsors now offer funds that are built using their own rules, which often reflect the trend toward “factor” investing. A factor may be driven by corporate sales, earnings, leverage, company size, valuation, momentum or almost anything else a fund sponsor thinks will attract investor dollars. Or you can decide to buy an ETF that focuses on specific industry sectors such as telecom, or financials, or technology. Does anything about navigating this landscape sound passive? Not a chance.

3. How much will you invest in each? After you select your asset classes and identify the funds you’ll use, how much should you put in each? The simplest method might be to put an equal amount in each, but that’s also the least thoughtful. Ideally, you would consider the risks of each fund and how they fit with your investment goals, and then allocate accordingly. Again, all this requires active decision-making.

So what is “passive investing”? All that means is we aren’t actively choosing among individual stocks, bonds and other securities, and incurring the associated costs. Instead, we’re simply buying the “market”—but even that’s subject to interpretation. The bottom line: Passive investing still leaves you with a host of decisions to make, all of which are undoubtedly active.

Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. His previous article was What? Spend It?

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Steve O
Steve O
7 months ago

I agree passive versus active debate is six of one and a half dozen of another.
When young start with VWENX and move to VWIAX in retirement.

stelea99
stelea99
7 months ago

While it is true that some decision making is necessary, it doesn’t have to be a complicated as suggested in this article. All one need do is Google Lazy Portfolios to discover simple approaches to investing. John Bogle, the founder of Vanguard, went thru a lot of his life with just a two fund portfolio. So, you can think about all the factors described in this article, or just go with a simpler approach. Humble Dollar is a good place to find info on important considerations such as how much risk one should take.

Jonathan Clements
Jonathan Clements
7 months ago
Reply to  stelea99

I agree with you that investing doesn’t have to be complicated — and just one or two funds can suffice. But for the record, Jack owned far more than two funds, including some actively managed funds. He bought those active funds relatively early in his investing career and I assume he was locked in by large unrealized capital gains. Still, when I heard him speak toward the end of his life, he had good things to say about some of Vanguard’s active funds, such as Wellington Fund.

parkslope
parkslope
7 months ago

My concept of active mutual fund management is that it typically involves a manager who moves funds in and out of funds and charges a fee for doing so. Passive management need not be nearly as complicated as the author indicates. One can invest in target date funds and forget about them or one can determine their asset allocation and invest in tried and true funds (e.g., VTSAX) and periodically rebalance.

Thomas
Thomas
7 months ago

Or you could just invest in VT. 😁 That’s about as close to 100% passive as you can get. I’m a little more active than that. I hold a total US fund and a total ex-US fund. The only decision I need to make is the split between the two. But now that I’ve made that decision, there is effectively no management that I have to do (my brokerage automatically rebalances dividends and new contributions for free).

Roboticus Aquarius
Roboticus Aquarius
7 months ago

For someone walking in off the streets, it can be very confusing. And yes, one can get hung up on what ‘passive’ really means. However, the basics are pretty straightforward and use only 2 or 3 funds.

Equities: Markowitz won a noble prize for suggesting you should own the Market Portfolio. It’s up to you to decide if US only is ok, or you want a Global Market Portfolio. Either is legitimate for long term investing. Many US investors park themselves somewhere in the middle, which is about 25% international, 75% US. Over the long run, which you choose may (should) be immaterial.

Bonds: For the portion of your portfolio you don’t want to put at risk (Markowitz, again) own Total US Bonds (Intermediate Treasuries is a fine substitution.) That’s about as close to a ‘riskless asset’ as it gets.

Asset Allocation: A 100% stock portfolio can lose 50% of it’s market price at any time. Can you experience that without selling? Many of us can’t, or at least need help to stay the course. For most of us, the buying is easy. The holding, in the face of steep market declines, is the hard part. So, if not, you need some bonds. Since the relationship is linear (an 80% stock portfolio can lose 40% at any time, etc, etc), decide how much of a loss you can bear and still not touch your portfolio. You now have your Bond percentage.

Having decided whether you want international stocks as part of your Equity alllocation, and what percentage of bonds to carry, you now have your AA. For a younger investor that might look like 60% US stocks, 20% Int’l stocks, 20% Bonds.

Target Date portfolios pretty much do this for you. What matters most is finding a reasonable allocation and sticking to it.

If you learn more, you may decide that it’s more sophisticated to have more than three funds, or to buy and sell various funds at different times.. That may be true, but it often isn’t. A lot of experienced investors end up with a simple 2 or 3 fund portfolio.

There is a lot of sophistication in simplicity.

greglee
greglee
7 months ago

” A 100% stock portfolio can lose 50% of it’s market price at any time. Can you experience that without selling?”

Yes. I’m 100% in stocks. I have experienced a 40% loss twice, recently, in 2000 and 2008. I don’t really understand the problem. I was never tempted to sell. It would have been stupid. In 2008-9, I bought more stocks.

Roboticus Aquarius
Roboticus Aquarius
7 months ago
Reply to  greglee

Good for you, I think that’s great! Stupid or not, many people are driven mostly by their emotions beyond a certain point. It’s good to know your risk tolerance. Many of my friends lack the emotional ability to survive big dips, but still deny the reality of their situation. That’s a setup for financial pain.

I’ve been through both those dips also. I rode out 2000, and I sold out in 2007. That last one luckily turned out better than buy and hold for me, actually, but wasn’t a smart strategy. I’m back to buy, hold, and rebalance. That’s what I did during the recent dip last March.

However, as I get closer to retirement & ‘winning the game’ as is sometimes said, I don’t want to have quite as much of my portfolio at risk. I’ve dialed back the risk to 80/20, and may go to 70/30 soon.

Greg Lee
Greg Lee
7 months ago

For those of us who are 100% in stocks, deciding whether or how to rebalance is not a problem.

Ormode
Ormode
7 months ago

You have to consider if index investing has distorted share prices, when everyone starts to do it. In order to do that, you have to know how to properly value companies based on their capital structures, cash flows, and business models.

In other words, in order to be a good index investor, you have to know how to be a good individual-stock investor. Otherwise, you don’t what your investment is really worth, which makes it hard to sit on your hands when the markets go down sharply.

Thomas
Thomas
7 months ago
Reply to  Ormode

This is something I worried about a lot when I began my investing journey a couple years ago. Michael Burry has famously raised similar concerns about index funds. The most clearly articulated counter-argument that I’ve heard is made by Ben Felix in this video: https://youtu.be/Wv0pJh8mFk0

If I understand it right, there is an equilibrium between passive and active investing. Obviously, if everyone went 100% passive that would be terrible. But the more people invest in index funds, the more inefficiencies there will be for active managers to exploit. In theory, this should keep the passive/active equilibrium from getting too out of whack.

Here’s another great video on the topic: https://youtu.be/1s7ULX45fjw

greglee
greglee
7 months ago

I bought some shares of an active mutual stock fund in 1972 and another in 1981. I still have them, and their returns have always been satisfactory. Much later, I heard about index investing, mostly from reading the Bogleheads’ forum, but I thought the arguments for it were simpleminded, and I bought more active funds. So that’s where I am now.

In the 70s and 80s when interest rates were sky high, I also bought some bonds. They were a good deal. But the era of high bond interest passed, and now, imo, they are definitely not a good deal. I’m aware of the argument that bonds moderate one’s losses when the market crashes, but folks don’t seem to be fully aware that bonds also moderate gains when the market is healthy. Not a good deal.

Roboticus Aquarius
Roboticus Aquarius
7 months ago

Phil, I agree that there is no such thing as purely ‘passive’ investing. Even doing one’s best to implement a ‘market portfolio’ can yield a lot of questions, some of which Markowitz answered (and other luminaries have suggested alternative solutions in some cases), and many of which he didn’t. Also, there are other approaches extant, such as the permanent portfolio for example, which come at the question from a very different perspective.

I agree that your three questions have many potential answers, and each time we put money to work, we are explicitly or implicitly answering all three.

So I’m curious, what do you think is the one or many appropriate answer(s) to these questions? I know that can go a thousand ways, but I’m wondering if you had something particular in mind? I think it’s really helpful when calling out difficult decisions to also provide some discussion of how one can address those decisions with some level of confidence.

Phil Kernen
Phil Kernen
6 months ago

Roboticus, sorry for the delayed response. I didn’t have any particular answers in mind when creating the post. It was more in response to the preponderance of views, at least in my experience, that talk of passive investing like making the right selections is the easiest thing to do. Which seems curiuos at at time when there are more more ETFs than individual stocks. In actuality, I think the issue investors are really rallying behind are fees, with good reason. Substituting index exposures for individual stocks or mutual funds is fine, but it doesn’t relieve investors of the need to be intentional, which can be applied in any number of ways.

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