Why Passive Investing Is More Active Than You Think

by on September 10, 2014

ETFs have greatly democratized and simplified the investment process over the years, making it easy and cost-effective for anyone with a brokerage account to employ virtually any sort of strategy. Along the way, the exchange-traded product structure has become more or less synonymous with the concept of “passive” investing; while countless traders have also embraced ETFs, it’s no secret that the bulk of the assets in the industry are controlled by longer-term investors who have embraced ETFs for their ease-of-use [see 101 ETF Lessons Every Financial Advisor Should Learn]. 

magnifyEven though most of the funds available on the market are linked to passive indexes as opposed to being actively-managed, there are still a number of important considerations to take into account before you can build a “hands off” portfolio. In fact, “passive investing” has become somewhat of a misnomer these days in the sense that even if you only utilize plain-vanilla products, there are still a number of active choices you must make along the way before you can flip on the “set it, and forget it” switch.

As such, below we outline three basic, but nonetheless critical, questions that ought to be taken into account as you build out your passive portfolio: 

1. How Will You Allocate Your Assets?

Making the decision to utilize passive, index-based funds for the sake of simplicity and cost-efficiency is a good first step. However, no matter how simple ETFs make the investment process, you still need to actually make the decision of how to allocate your assets; more specifically, this means answering the question of how much of your portfolio will be stocks, bonds, and/or other asset classes you may wish to hold, such as commodities. Depending on your individual goals, risk preferences, and investment horizon, the suggested asset allocation will vary from person to person [see also Want a Simple, 3-ETF Portfolio? Here Are 25 Of Them]. 

Feeling stuck? Consider any of our 50+ All-ETF Model Portfolios for ideas; note that the ones listed below are based on a person’s investment horizon:

2. Which Way Will You Gain Exposure?

After you determine your asset allocation strategy, you still need to make some active decisions before you can truly call yourself a passive investor. Next on the list is answering the question: within each asset class, how will I go about gaining exposure? For example, let’s suppose you’re set on a simple split, 80/20, stock/bonds; within your portfolio’s stock component, you have to decide how you will divide up your assets among domestic and foreign equities, as well as what size of companies you will focus on [see also 25 Things Every Financial Advisor Should Know About ETFs]. 

applesBelow is a list of the broadest categories in the equity and fixed-income asset classes; investors can utilize this list to assist them when it comes time to determine how exactly to divide up their assets within the respective stock and bond components in their portfolio.

Stocks

Bonds

3. What is Your Index Methodology?

Now that you’ve determined your asset allocation and you’ve even decided which types of funds you will utilize to tap into the various asset classes that you’ve selected, there is yet another decision you have to make before you can flip the “hands-off” switch. Last but not least, for some asset classes, you will need to pick an index methodology; that is to say, in some instances, there are several ETFs targeting the same asset class, but some undertake a slightly different approach when it comes to weighing their underlying securities [see also The Truth About Alternative Weighting Methodologies]. 

Here is a quick primer on the most popular weighing methodologies available in the ETF wrapper: 

  • Market Cap: This is the most popular weighting methodology and it’s very straightforward – the bigger the market cap of the security, the greater the weight it receives in the underlying portfolio.
  • Equal Weighted: As the name suggests, this methodology holds an equal dollar amount of each security. In this case, smaller companies receive the same amount of exposure in an index as larger ones. 
  • Dividend Weighted: This approach ignores market cap altogether and instead affords the biggest weight to the company that boasts the biggest dividend. 
  • Earnings Weighted: This strategy weights each component based on reported earnings; simply put, companies that generate higher cumulative earnings account for a greater portion of the underlying portfolio. 
  • Revenue Weighted: Similar to earnings-weighted, this approach relies on top-line revenue metrics to determine security allocations. 

Read more about how alternative weighting methodologies have performed over the years. 

For stocks and bonds, you also have to decide whether you will opt for a fund linked to a local currency-denominated index or one that is U.S. dollar-denominated. While this decision may seem trivial, the effects of currency fluctuations can actually have a major impact on your bottom line returns. Consider the following resources for more information on why currency risk matters and the various options available to ETF investors who wish to minimize it:

The Bottom Line

You’re not done yet. After you have answered the above three questions you should still take the time to thoroughly consider all your options and look under the hood of each one. Often times there are nuances that you might miss at first glance, which can turn out to be a costly mistake if the fund that you’ve selected doesn’t jive with your overarching investment objective. The key takeaway here is that passive investing is not as simple as flicking a switch; there are several important questions that investors must consider before pulling the “buy” trigger.

Follow me on Twitter @SBojinov

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Disclosure: No positions at time of writing.