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.
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?