A recent memo from billionaire investor Howard Marks seemed to rekindle debate over active and passive investment management or, more specifically, how both should be defined. Howard (correctly) observed the increasingly blurring line between active and passive:
“Each deviation from broad indices introduces definitional issues and non-passive, discretionary decisions. Passive funds that emphasize stocks reflecting specific factors are called “smart beta funds”, but who can say the people setting their selection rules are any smarter than the active managers who are so disrespected these days?”
My response: What difference does it make? Look, I have been as guilty as anyone of beating the “passive” drum over the years. But, at the end of the day, unless your portfolio perfectly replicates the world’s total financial assets/securities, any decision you make is ultimately active.
How much do you own in U.S. stocks, international stocks, bonds, real estate, gold? Those are all active decisions. Within each of those asset classes, how are you accessing exposure? Market cap weighted indexes, smart beta, traditional active management? Active decisions.
Even within what many investors would view as traditional “passive” investing – market cap weighted strategies – active decisions are being made. Consider the gold standard for passive stock investing – the S&P 500. Guess what? A committee determines the composition of that index. Yes, there are guidelines used to determine index constituents, but they are actively created by people and subjectivity is involved in the selection process. From David Blitzer, Managing Director & Chairman of the Index Committee:
“Applying these guidelines to companies not currently in the S&P 500 yields a list of several candidates for the S&P 500. The selection is made by the Index Committee.”
The entire active versus passive debate comes down to this: which strategies provide YOU the best opportunity to stick with YOUR investment plan and meet YOUR financial goals? If you can’t stick with a low cost S&P 500 index fund through the ups and downs or if you don’t like the idea of simply capturing “market” returns, then it’s probably the wrong strategy for you. You won’t be able to stay with it through thick and thin. If you can’t stomach an active manager underperforming for potentially long stretches of time… not the right strategy. If you can’t allow your “smart beta” value ETF to work its magic over a full market cycle (or maybe longer), sorry – wrong strategy. Investor behavior trumps all. Period. End of story. The best investment strategy is the one you can stick to.
Let me repeat that: Investor behavior trumps the active/passive debate. Single factor or multi-factor. Value or momentum. Doesn’t matter. Investor behavior always wins. It also happens to trump investment costs too. It doesn’t matter if you save 50 basis points on your index fund if you’re inclined to day trade it. Taxes, transparency, whatever. None of it matters if you exhibit poor investment behavior.