The debate over passive and active investing has long divided portfolio managers. While both sides of the debate offer important insights, there’s a strong case to be made that no investor is truly passive.
After all, investing in today’s climate means being willing to revise your portfolio and asset allocation strategy at any given moment in response to changing market dynamics.
Passive Investing vs. Active Investing: The Historic Debate
Without arguing over semantics, it’s important to understand what is meant historically by “active” and “passive” investing. As we will soon find out, these definitions are limited and do not reflect the reality of today’s investment climate.
Historically, the active investor was considered any individual that takes a hands-on approach to asset selection and portfolio management. Their goal is simple: beat the stock market’s average return and capitalize on short-term price fluctuations. As the name entails, active investing requires a much more detailed analysis of the market in order to identify the right stocks or assets to play at any given time.
On the flipside, a passive investor has a long-term horizon, and they are perfectly content adopting a low-effort, cost-effective strategy to generate their return. This usually involves a buy-and-hold mentality whereby the investor would select an index fund and hold it indefinitely. Usually, passive investing involves cost-averaging that index fund over time to maximize holdings and returns. Two of the most noteworthy buy-and-hold investments have always been the S&P 500 and Dow Jones Industrial Average.
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Active vs. Passive Investing in Today’s Market
Beyond the obvious facts that modern investors need to be nimble, the rise of low-cost index funds has transformed the way in which we access the financial markets. After all, investing in today’s market means you are no longer tracking passive indices since you can monitor every corner of the financial market by way of hedge funds, leveraged exchange-traded funds (ETFs) and market-cap-weighted index funds.
What’s more, index funds that call themselves “passive’ but offer hedge fund ETFs, leveraged volatility products or plain vanilla index funds aren’t really passive because they track strategies that have been traditionally referred to as active holdings. The same holds true of any fund that tracks asset classes such as real estate, venture capital, private equity or commodities. These investment vehicles are very much based on an active decision to generate above-average yield. They also require an active decision to diversify one’s portfolio away from the traditional equity market gauges.
Deducing from the above, there is only one kind of passive investor: one who simply seeks to take the average market return instead of trying to beat it. In this sense, passive investment can be described as any asset allocation strategy that adopts low frictions in an attempt to take the market return. Of course, adopting such a strategy leaves very little selection in terms of funds or even asset classes. An investor who purchases anything other than a global-cap-weighting index is essentially saying he or she can beat the market on a risk-adjusted basis. This makes them very much an active investor.
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Also, you can compare how hedge funds as a subgroup compare with other subgroups of alternative ETFs – for example, long/short.
Investing Entails Active Decisions
Regardless of your underlying goals, investing usually comes down to active decision-making. This extends far beyond asset selection to include risk exposure and tax considerations, among other variables.
Tax considerations are top of mind for most investors. Even so-called passive investment strategies entail selecting the most tax-efficient strategy. Even investors who select passive strategies must still decide which taxable accounts to follow. For example, should higher tax bracket investors own fewer junk bonds and more low-dividend growth equities? At the same time, assets such as U.S. municipal bonds are essentially useless for non-U.S. investments, which makes the decision to enter them or not an active one.
Then there’s the question of risk-return expectations, which will depend entirely on the individual investor’s goals and risk tolerance. Identifying your risk-reward profile and executing a strategy that meets it is also an active decision, and one that cannot be said to be passive. After all, investors with a higher threshold for risk are willing to take more chances in selecting assets that beat the market.
Beyond these obvious considerations are other active decisions that all investors must consider when developing their portfolio. Things like currency exposure, home country bias and exposure to liabilities may not be “active” in the sense that you think about them all the time, but they certainly require the decision-making faculties. In other words, one cannot factor these variables and still be considered passive.
The Bottom Line
Indexing expert Rick Ferri once said, “Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist.” A careful examination of so-called passive investment strategies certainly reveals this to be the case.
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