09132018

Passive Investors: You Are More Active Than They Think
(And that’s probably a good thing)

September 13, 2018

Are you an active investor? Even if you are a die hard, low cost index or ETF aficionado, you are probably much more active than you realize – and that’s likely a good thing for your portfolio. Investing is not an either/or proposition, and most industry experts suggest that investors incorporate a combination of active and passive strategies in their investment plan since both can add value to a portfolio. Sounds logical, but the waters quickly become murky - after all, how do you define active management? 

Generally, active management refers to what might be called ‘traditional’ fund management where a manager is making judgements on what securities to buy and sell based on research in line with a specific investment objective. In contrast, passive management refers to index based funds which track a specific benchmark – such as the S&P 500 – with the promise of delivering ‘market’ returns or ‘beta.’

Passive funds are often perceived as not actually being managed – though they are periodically rebalanced when the stocks in the underlying index are revised. In fact, some experts make the argument that all investing incorporates some active elements. A common example cited is that even creating a portfolio entirely of passive products is itself an active decision. This sets up another complication: beyond products, there are many different investing techniques that also fit along a range.

So in addition to viewing the active and passive products along a spectrum, it’s helpful to distinguish between common fund products and techniques that incorporate different active elements. The nearby infographic outlines this spectrum using common products and techniques. This is by no means an exhaustive list!

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At the product level, traditional index funds and ETFs, which are based also based on indexes, are generally considered the most passive choices. The funds will own a portfolio of stocks that approximate the holdings of whatever index the fund is tracking.

Moving along the product spectrum, products start to become more active. The newer Smart Beta index based products are a prime example of a “passive” product that has an embedded active bend. Though they are not managed actively in the traditional sense, Smart Beta indexes (and the funds based on them) are weighted based on a factor or characteristic using a rules based, transparent methodology. These are different from traditional index which are typically based purely on market capitalization. Active ETFs are yet another product innovation that confuses the discussion. Active ETFs essentially deliver an active strategy in an ETF wrapper.

Target date funds adjust holdings in line with investors’ time horizons. These funds will own a mix of assets becoming more conservative as the investor approaches retirement age – their “target date.” Lastly on our list are traditional mutual funds which follow different sectors, asset classes or themes. In these funds, managers devote significant resources to different forms of research and analysis to evaluate massive amounts of data and information on companies, market conditions, interest rates, geopolitical events and much more. 

Moving to the investor’s portfolio, there are host of techniques that require active management in different forms. The most passive technique is to Buy & Hold a portfolio of stocks or funds. The theory behind this technique is that buy owning and not trading the holdings, investors reduce trading and tax costs.

Speaking of tax -- investors seeking to reduce the tax impact on their portfolios may engage in tax loss harvesting. Though most often associated with year-end selling, tax management is actually a year-round process of strategic trading. Similarly, the rise of ESG and the related concept of Responsible Investing also require active management. These portfolios are constructed in line with investors’ values and might include faith based rules governing portfolio holdings or personal preferences such as the avoidance of firearms manufacturers or tobacco stocks. Still others may seek to effect social change by only including companies that have balanced representation of women on their boards. Obviously, construction the initial portfolio is just the beginning as these portfolios require ongoing monitoring and trading.

Quantitative Model investing represents a wide category of strategies that utilize complex tools and mathematical models to identify investment opportunities. All trading decisions are determined by the model, not human judgement – and many trade with high frequency.

At the most active end of our technique spectrum are multi-asset portfolios and financial planning. With multi-asset portfolios as well as a range of related approaches, managers create customize portfolios that include a range of securities that are continuously monitored and traded in line with the investment philosophy of the manager.

The point is that investing requires constant evaluation, recalibration and adjustment. Even a “passive only” portfolio requires active decisions and continuous management. When investors develop an investment plan (ideally with the help of a professional financial adviser), there is no “one-size-fits-all” solution because every investor has unique goals and considerations that require a mix of investment products, solutions and approaches. Understanding the range of options and techniques can be helpful to making better decisions.