What entails being a passive investor and why most are NOT.

The common perception is that if one invests in ETFs or indices like the S&P 500, one is being “passive”. The media have additionally confused the definition by considering any strategy that is rule-based or systematic as passive investing. This poor understanding has led many investors attempting to create a passive portfolio to end up poorly diversified. Furthermore, it has introduced unnecessary risk into their portfolios. The goal of this post is to clarify the meaning of passive investing.

Defining the market:

The academic term for passive investing refers to investing in the market portfolio. This is peculiarly important since that’s the return we would be trying to match. But what is the “Market”? Note, we have the market, and then we have sub-markets. Take the market for fruits, for example. On the one hand, you have all the fruits in the world, and on the other you have the sub-market of apples in different colors or sorts (not an apple expert). Thus, in the same way that we have the market for all available investable assets in the world, we also have sub-markets for the separate asset classes (equities, Treasuries, REITs, commodities, and so on). The market portfolio is the aggregate portfolio of the world.

Defining passive investing:

Passive investing is not exhibiting preferences towards different asset classes (sub-markets), different securities, different factors (growth vs. value), etc. A passive investor takes what the market gives them, meaning the relative market valuations. Thus, the passive portfolio involves holding all the securities and asset classes in their respective value-based weights. Put another way, securities are weighted based on their market capitalization divided by the market capitalization of all financial assets. Further, passive investing is not reducing fees, minimum trading, or investing in an index. All those are byproducts, and since it’s inexpensive to replicate the market, it doesn’t involve a lot of trading (actually no trading since weights will automatically adjust if indeed passive), and is easiest achieved through using value-weighted index funds. Nevertheless, you can have all those characteristics but still have an actively positioned portfolio.

Examine the below estimate of the global market portfolio based on asset class. I guess it is not what some expect.

Contrast to active investing:

Active investing is deviating from the market, such as having an overweight or underweight position (exhibiting preferences).  For example, if one invests all their money in a US equities portfolio such as a value-weighted index (Wilshire 5000), they are active. In this extreme case, the investor is being bullish on US stocks, and bearish towards bonds, international equities, real estate, emerging markets, etc. Just as you can be overexposed to a company stock, you can be overexposed to a country, asset class, specific factors like growth stocks, and so on. To be passive, an investor has to hold all the assets weighted in the portions they exist in the market. If your allocation is anything else but the market portfolio, you are taking an active position.

“One can be passive concerning a particular sub-market, but be actively positioned overall.”

Take the case where someone bought the Russell 1000 index fund, investing in US large cap stocks. Yes, they will get the average return of all the investors who hold the Russell 1000 companies, but their performance will vary compared to other asset classes and the market.

So, are you passively invested? I would take an active bet that you are not. Many investors exhibit biases and preferences. Most of us either exposed to a lot of US equities, and bonds, or are exposed to certain factors, etc. There is nothing wrong with that as long as you understand the difference between your portfolio and the passive portfolio. Recognize risks and the current positioning of your portfolio. One will have many reasons to deviate from the market portfolio throughout their life (age, kids, home purchases, etc.). The point is that if you have any active weight versus the market, you are not passive. All those equal-weight (overweight small caps), value, growth, and so on strategies are active strategies. Also, don’t confuse passive investing with indexing or ETFs; both, if applied correctly, are tools to achieve a passive portfolio efficiently but are not what constitutes being passive.

Sources:
The Global Multi-Asset Market Portfolio 1959-2011, Ronald Doeswijk, Trevin Lam, CFA, and Laurens Swinkels.

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