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Is Passive Investing an Illusion?

Perhaps the difference between passive and active management is more gray, than black and white.
  1. Philosophies - Discuss four broad approaches to investing.
  2. Perspectives - Introduce the three main players in the industry.
  3. Illusion - Define the term and lay out the case.
  4. My Viewpoint - See why one answer becomes clear.
  5. Learn more - Learn how you can gain quantitative skills faster.
by Paul Alan Davis, CFA, September 22, 2018
Updated: September 22, 2018
At the institutional level subtle concepts like this become more clear. So sharing that view is our mission. Keep reading.

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Where does passive management begin and end?

Beginner

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Career Talk in Video

Is Passive Investing an Illusion? (12:05)

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Video Script

Introduction and Outline

Welcome, I'm Paul, this is Career Talk and today's topic is:

Is Passive Management an Illusion?

Here is how I'll tackle this one. First, I'll cover four investment philosophies, then as is the pattern with these Career Talk questions, I'll segment the players into three different groups. Third, is the term illusion. Fourth, I'll share my potentially controversial view and fifth, I'll show you where you can learn more.

Okay, let's have some fun.

1. Four Investment Philosophies

First off, let's talk about four broad approaches.

Passive Investing

First, passive investors believe that active portfolio management does not work, especially after costs. Instead they buy broadly diversified pools of stocks or bonds in an index mutual fund or ETF. Security weights are based on market capitalization or other characteristics as determined by index providers like Russell Investments, Standard and Poor's, and Dow Jones.

The next three are forms of active management, meaning the portfolio manager deviates from the benchmark by actively underweighting and overweighting securities.

Fundamental

You can think of a Fundamental approach as the in-depth analysis of a company's financial statements, competitive position, industry and the macroeconomic trends impacting that company. The fundamental analyst attempts to find mispriced stocks and invest accordingly.

Technical

Technical processes relate to selecting stocks based on past price movements. The goal here is to find stocks that have price momentum, based on visual patterns found in charts.

Quantitative

Quantitative approaches use computers heavily to evaluate thousands of stocks at once. This approach attempts to maximize a forecasted return-over-risk-ratio, leaning heavily on Statistics and capitalizing on mispriced securities through diversified portfolios.

Objectivity

Last, as covered in more depth elsewhere, each approach has its own strengths and weaknesses. If you follow FactorPad, you know I don't align with any one philosophy, instead seeing each one a piece of the valuation puzzle. There is no right philosophy.

This requires objectivity, meaning I don't have a vested interest in spinning a viewpoint for financial gain.

2. Industry Perspectives

Let's get a visual and short perspective on the two industries where I focus my energies.

With a background in Finance and Technology, I categorize content along two scales and try to help Subscribers climb learning curves faster. So content is geared for those with the following educational backgrounds, job titles, skills and designations.

The orange circle zeroes in on the difficulty level here, meaning I won't go into minutiae about academic research, but I will point you to one important article shortly.

That said, the reason for this slide is to segment market participants into three groups.

Individuals Professionals Institutions

Here's how I think of it.

First, some Individuals manage their own stock portfolios, however most entrust their money to Professionals like financial advisors, wealth managers, financial planners, investment advisors and brokers.

Second, some Professionals manage client portfolios themselves, however most entrust this money to Institutions in investment pools like mutual funds, pension funds and even hedge funds.

There they manage stocks in one portfolio which benefits shareholders with economies of scale and allows portfolio managers to specialize and focus on performance.

When we look at our question "Is passive investing an illusion?" from the institutional investor's standpoint the answer becomes clear, so next let's look at that perspective.

3. What is an Illusion?

But first let's define illusion.

illusion  noun
a deceptive, false or misleading impression of reality.

To apply that to our context, and because I don't know if you're familiar with me and my tutorials, I'll do a two-minute backgrounder of material covered elsewhere.

Basically, I train people to see things through the lens of an institutional investor, because that's where the pay and job security is best for analytically-minded individuals.

For this, I'll borrow visuals from another presentation and point you to it at the end.

Benchmark

First, institutional investors know that all investment products should have a suitable benchmark and know its constituents, metrics and how it is rebalanced and weighted. After all, it is the bogey against which they are measured.

Peer Group

Second, they also compare all investment products against a peer group as a way to evaluate performance for similar managers.

Returns

Third, they know how to filter through misleading charts that look impressive to the novice, but under further analysis with shorter sub-periods or rolling-periods, results turn out to be less impressive.

Risk

Fourth, institutional investors know how to analyze risk using a linear regression, and are comfortable with rolling regressions that paint a more accurate picture of what happened over time.

I call this the Scoreboard, because it is what separates winners from losers. It can't be manipulated, and in the end, it is all that matters.

That's the quick review so we're all on the same page. Now, let's talk bring it all back to passive investing and the illusion.

Asset Allocation

We covered the relationship between Individual investors and the Professional's category earlier.

The term "asset allocation" comes into play here as it is an important service Professionals offer to Individuals. Basically, it refers to how a portfolio is constructed, with weights to each asset class, so the overall portfolio meets the investor's goals, time frame and tolerance for risk.

So traditionally, a portfolio would be broken up into weights to stocks and bonds. A level deeper are allocations to domestic and international companies. Styles here refers to other segments, like large and small companies, growth and value stocks, even industries.

On the fixed-income side, the allocation to bonds can be further segmented by time until maturity and type of bond, like Treasury or municipal.

These are all considered factors and because of their importance to me and what I publish here, the term factor made it into the company name.

The concept of asset allocation is likely not new to you, but if you'd like to brush up on it, I put a link to a Wikipedia article on Asset Allocation in the video's Description. Besides an adequate review, it offers a summary of a highly influential academic paper.

4. Is Passive Management an Illusion?

Let's back up a moment and then touch on that paper.

The state of the wealth management industry in the 1990s

Many of the best wealth management firms, by rankings in the US anyway, raise assets by offering a variety of financial planning, tax and asset management services. One way they differentiate themselves is with their approach to asset allocation and the selection of funds in each category.

In the 1990s, after the dissemination of what is know as the Brinson, Hood and Beebower academic paper, many Professionals, in the US anyway, were now armed with a short sales pitch that effectively went like this.

  • "Active management is a waste of effort and money, passive investing is the way to go. Asset allocation determines 94% of your return anyway, so invest with me and for a fee of 1% of your assets per year, I'll allocate your portfolio to index funds managed by Vanguard or Dimensional Fund Advisors."

This became a popular business model. I'm not knocking it at all; it was a much better offering than many alternatives at the time.

So the term "passive investing" was all the rage and it was much easier to sell. Active managers became the scapegoat and were often conveniently mentioned in the same sentence as Wall Street greed.

As a result, assets flowed to index funds and everybody was happy, except active asset management firms who needed to spit out index offerings to compete, or come up with a new buzzword.

The Illusion

And therein lies the illusion I'm referring to. Yes the term "passive investing" may accurately describe how each individual index fund is managed, but it shouldn't be used to refer to the whole investment process.

Why? Because someone needs to decide how much to invest in each fund, so the asset allocation, right? And that is an active decision.

Asset allocations just don't fall from the sky, right?

On top of that, it would take away from the overall argument for a passive advisor to say, "I practice both active and passive management" because the two are characterized as enemies, like Republicans and Democrats in this country.

After demonizing active managers this investment advisor couldn't say they are partially active, so instead they ignored or downplayed their active role, instead repeating the "passive investing" buzzword over and over.

That to me is the deceptive, false and misleading part of the term "passive investing" and a reason I call it an illusion.

Index funds

Don't get me wrong, index funds have merits. Among them are low costs and turnover, broad diversification and little style drift. They allow anyone to build inexpensive and diverisified portfolios.

So folks like Jack Bogle, the father of indexing from Vanguard, and while I love what he has done for investing, he doesn't tell you how much to allocate to each index fund because that is a personal decision based on each investor's risk tolerance. And guess what, that's an active decision.

So back to the industry, because individual investors still needed to solve this "active" asset allocation decision, Vanguard and others, offered new funds called "retirement date" and "target date" funds. Today when this advice is distributed through the Internet, we call them "robo-advisors".

Everyone wants downplay or ignore the "active" word because of its connotations with overpriced products that underperform their benchmarks, but if you step back and think about it, somewhere someone is making an active decision.

Investors Buy the Buzzwords

If you're picking up a theme, herein lies my frustration with the industry, an overreliance on buzzwords.

Now fast forward to 2018 and what do we have now? More buzzwords.

I'm certain a salesperson pitching a smart beta fund that employs machine learning and AI would be able to open more doors than a "Quant" fund, especially after the bad press they received after the financial crisis. When you look under the hood, they may actually be the same thing, computers making investing decisions.

It isn't unique to Finance, in Technology the procedures involved in "data mining", "machine learning" and "data science" aren't far from plain old Statistics practiced since the 1970s, but they sure sound better than the term Statistics.

Buzzword du jour in Finance and Tech:
  • Smart Beta = Active / Passive Hybrid
  • Structured Fund = Active / Passive Hybrid
  • Robo-Advisor = Asset Allocation Model
  • Target-date Fund = Asset Allocation Model
  • Lifecycle Fund = Asset Allocation Model
  • Artificial Intelligence = Statistics
  • Data Science = Statistics
  • Machine Learning = Statistics
  • Algorithm = Computer Program
  • Cloud = Internet

What this does is create more and more confusion. So instead of Individual investors buying index funds, now they can fill their portfolio with buzzwords. So that traditional asset allocation conversation may have morphed into something like this.

Bob: Hey Charlie, tell me about your asset allocation.
Charlie: Thanks for asking. I have my assets spread across liquid alt, cryptocurrencies, smart beta, FANG stocks, global macro, and an enhanced yield bond fund. I invest only in index ETFs though, because passive investing is the way to go.
The Scientific Approach

You get my point.

In my view, we've lost track of what is most important and that is the scoreboard from earlier, with these components:

  • What is your benchmark?
  • How are you doing against your peer group?
  • What are your returns?
  • How do they look on a risk-adjusted basis?

These are not buzzwords. These will never go out of style. These measures are what matter, or what should matter, to all investors.

But because this scientific approach takes time to understand and requires a modest amount of math, only the most curious and motivated people gravitate to it.

5. Where Can You Learn More?

Okay, so where can you learn more about the scientific approach?

Resources at the FactorPad website and YouTube Channel include web development and data analysis tutorials on the Tech side.

Currently, about 1,000 times a day visitors review some 330 web pages and 250 videos, and here I've provided measures and demographics.

On the Finance side, the slides from earlier were from a tutorial titled The 10 Steps to Writing a Pitch Book for Institutional Investors.

If you have time, likely the best resource to try out is the freely-accessible course Quant 101, a series of 30 tutorials I use to teach a college course on financial modeling.

The point with Career Talk is to bring up thought-provoking topics so you can share your viewpoint. I'd love to hear what you think with a quick post in the Comments section on YouTube.

There you have it. If you have questions or feedback please leave a comment and subscribe for more of the scientific approach, in Career Talk.

Have a nice day.


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