Within the financial advising industry, my portfolio management style is described as “passive index investing”. It was undoubtedly named by the advisors with the opposite investing style – known as “active investing”. Active investors attempt to beat the market using various analyses and timing strategies. Passive investors buy and hold the market, trying to capture and retain as much of the market return as possible by minimizing fees and taxes. After recently spending 5 hours developing a client’s portfolio I started to think maybe the name – passive investing - isn’t very accurate. Five hours of work seemed like a lot of activity for a portfolio management style that gets labeled passive.
Developing any portfolio requires making a series of decisions. Whether you are selecting individual stocks or indexed funds, those decisions are actively made. You establish the investment objectives and risk tolerance, you evaluate securities, and you determine the appropriate portfolio structure. If you are attempting to pick individual stocks or time the market you must make more of these decisions per unit of time, but that does not mean there is a lack of activity associated with index investing.
The primary difference is the timing of these decisions. With the strategy known as passive investing the majority of decisions are tied to life stages or life events. Once the portfolio is established we usually only make decisions on changing it as the distance from retirement changes (life phases) or a significant life event (marriage, birth, promotion, inheritance, etc.) happens. Otherwise we rely on the economy and the markets to do the work they have always done for us.
With the strategy known as active investing there are many more opportunities to make decisions. How is specific information impacting the securities we hold? Is the market signaling a buy or sell? Etc. Information must be evaluated daily and the appropriate reaction to new information must be determined. I would even go so far as to say the primary difference between the strategies known as active investing and passive investing is the higher incidence of reactivity in active investing. If there is one thing to remember from behavioral finance, it is that being reactive is rarely profitable. Especially in the long run. As a wise man once told me, “Don’t just do something, sit there!”
Let’s take a closer look at the active decisions being made when developing (and maintaining) a passive portfolio. Among them are:
Asset Allocation. In the broadest sense we think of allocation as the ratio of stocks to bonds in a portfolio. What if the investor also holds real estate investments? And what about the ratio of US to foreign stocks? Government to corporate bonds? In a truly passive global index an investor would only own about 37% stocks, half of which would be non-US. A portfolio that is only 19% US stocks is not one I can get behind. Choices must be made on weighting asset classes. To make those choices additional issues must be considered.
Risk Exposure is one of the factors used to determine asset allocation. What are the investor’s objectives and what additional risk is worth taking to achieve those objectives?
Index Selection, based on risk exposure, is another decision that must be actively made when developing a portfolio. Should we be targeting large caps known for value? Or do we need the additional return (and risk) of small cap growth stocks to meet the investment objectives?
Asset Location is a much bigger deal than most people realize. Some securities pay interest. Some pay dividends. Some pay capital gains. Some pay a combination of these three types of income. Dividends, interest, and capital gains are not given the same tax treatment under the law. Individuals typically have access to accounts qualifying for tax exempt status, deferred taxation, or accounts that do not qualify for any preferential tax treatment. You gain maximum tax advantage by locating the assets paying certain income streams to the accounts that create the best tax advantage for that income stream. For example, to the greatest extent possible you would want to avoid holding bonds generating taxable interest in a nonqualified account because taxable bond interest is taxed at normal income tax rates.
Qualified Account Evaluation also comes into play with asset location. Not all employer sponsored retirement plans (a.k.a. 401(k) and 403(b) plans) are created equally. Some are quite good and I might recommend using it to its full extent. Others are not as good and the investor might be better off funding an IRA instead of fully funding their employer-sponsored plan.
Fund Selection. Once I have determined the indexes in which to invest I still need to pick an actual fund. There are many versions of each. SPY and VOO are the ticker symbols for two different S&P 500 index ETFs. Which of these should I choose, and why?
Fund Availability within employer-sponsored retirement plans is also a factor in these decisions. Most employer-sponsored plans have a limited number of fund options from which to choose. I want to be certain I am getting the best fund options within the plan, consistent with the need to satisfy the best asset location strategy.
Rebalancing must be done periodically over the life of the portfolio. If you are still accumulating assets then your monthly or annual contributions can be used to create some balance each time new securities are purchased. If you are decumulating or the portfolio is very large in comparison to your regular contributions then more frequent rebalancing may be needed to keep the asset allocation of the portfolio aligned with the investment objectives.
Tax Loss Harvesting is a technique used to squeeze a little extra tax efficiency out of nonqualified investment accounts. While opinions on its impact vary widely, it can be useful. It needs to be judiciously applied, however, and can be used in connection with rebalancing and asset location strategies.
That all adds up to a lot of activity in the development and maintenance of a so-called passive investment strategy. It's almost as if someone is intentionally trying to mislead investors about the value of passive management.
Wall Street trying to mislead Main Street? Naah! That would never happen!