In Friday’s post, I discussed Charles D. Ellis’ book, The Index Revolution. Any time I read a one-sided take on a topic that is so hotly debated, I try to look for the other side of the story to try to balance my perspective. The following is a combination of prior research and some blogs that I have visited over the past few days in trying to balance out the arguments against passive investing.

There is no such thing as true passive investing.

Unless you buy and hold securities in all the various assets classes of the world in their relative proportion, then any deviation you make from that composition is an active investment choice. Don’t own a commodities fund? Then you’ve made the choice to underweight commodities. Own 70% stocks/30% bonds, then you’ve made the choice to overweight stocks compared to the world’s allocation of about 45%/55% stocks/bonds.  Using the S&P 500 as your U.S. index fund? Then you’ve made the choice to favor that index over other U.S. stock indices and to use a market-cap weighted index over some other weighting mechanism.

I believe this is a valid point about passive investing, which makes it a bit of a misnomer. That said, it is far easier to say “passive investing” with almost everyone knowing what you mean, than it is to say “buy and hold using low fee index funds in a portfolio allocation that will slowly become more conservative over time understanding that the portfolio varies from the world’s asset allocation and therefore its not truly 100% passive”. What is important is that we all understand that active bets are being made even with passive investing.

Passive investing loses to the market 100% of the time, whereas active investing can beat the market.

This argument is technically true, but it is too simplistic. Passive index investing will lag its index by the mutual fund or ETF’s fees and the investor’s taxes 100% of the time. Active investing, in the aggregate, will lose to a given comparable index by an amount equal to its fees and taxes, except that in most cases those fees and taxes are higher. While many active investors beat the market any given year, in gets harder and harder to do so over time. Some of this is explained by the additional fees and taxes incurred over time, and much of the rest is explained by the world of behavioral finance, which attempts to figure out why we are our own worst enemies when it comes to investing.

Then there’s Warren Buffett.  There is no substitute for his article about Graham and Doddsville and why, in a world of investing failures, he and many like him have had long-term success. Note that Buffett is as close to buy and hold as almost anyone can be still owning stocks, that he sometimes dabbles in bonds, preferred stocks and options when he deems appropriate, and that he often finds tax-advantaged methods to sell his stocks, few of which we as individual investors can use. Of course, we all have to keep in mind that we are not Warren Buffett.

Passive investing can require a greater risk tolerance than active investing.

It appears that active investing is riskier than passive investing because the average loss of active investors is greater than passive investors, and active investors have a significant spread of outcomes whereas passive investors have only one outcome: the index’s rate of return less fees and taxes. However, passive index investing is 100% invested at all times, meaning that during the 2000 and 2007 market crashes the passive investor has to be willing to ride out a 50% drop in his or her stock holdings, and few did.

There are some investment methodologies that, if consistently and correctly applied, could make active investing less risky than passive investing. Such methods include some form of tactical asset allocation as described by Mabene Faber, Wes Gray and others. There are even some extremely simple methods tied to the Shiller P/E ratio or other valuation methods that use just two or three low cost ETFs much like buy and hold, but have triggers to sell some of your holdings at certain times and then buy back in upon certain events. Many of these methods, if consistently followed, may provide returns that are similar or better than the market with much less risk but with slightly higher trading costs and fees than buy and hold (but likely still much less than active mutual funds).

Investors have such a strong tendency to panic by selling at a market low and buying at a market high that most people would benefit from an investing system that will decrease the odds of making such mistakes. The potential drag on returns from additional taxes and fees in would be more than outweighed if it helped an investor get out of the market after a 20% loss and then back in at around the save level a few months later compared to that same investor trying to ride out what ends up being a 50% loss, then panicking and selling at the bottom only to buy back in two years later after the market fully recovered. This only has to happen once to destroy the benefits of passive investing. In addition to attempting to avoid the lowest of lows, many of these strategies help decide when to reduce market exposure and risk, as opposed to passive index investing, which is typically 100% invested at all times.

Conclusion

Hopefully the above discussion paints a more moderate view of the passive/active debate. I am not attempting to sway anyone’s opinion; rather, I seek to understand how our investment choices fall on the continuum of risk and return, with costs and taxes being the most controllable part of the analysis, and potentially the most significant.  I hope to continue to write about this topic over the next few months. For what its worth, my clients decide their preferred methodology based on their risk tolerance, proximity to retirement goals, and our conversations.

-Richard

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