We’re all Active Investors

This is a good piece by Rick Ferri on the myth of passive investing.  In essence, he notes that we’re all active investors.  It’s just that some of us are less active than others.  Rick veers towards the less active side and I mostly agree with him there.   He says:

“Then I realized, it’s not the actual process of portfolio management that determines if a strategy is passive or active; it’s the goal of the strategy that makes the difference.

A passive strategy attempts to track the market(s), even though it’s understood that market indexes are active themselves. It’s a passive strategy when an index mutual fund’s goal is to track the performance of a benchmark. It’s also passive when an investor selects a fixed allocation to low cost index funds and ETFs and trades these funds to closely maintain the target allocation.

In contrast, an active strategy exists when a fund manager knowingly and willingly attempts to beat a pre-designated benchmark. It’s also active management when an investor or adviser attempts to beat a blended benchmark of appropriately selected indexes. The success or failure of active strategy is always measured on a net-of-cost, risk-adjusted basis against its benchmark.

Pure passive investing does not exist, but that shouldn’t matter to passive investors. When the goal is to be the market rather than beat the market, that’s passive in my book.”

I phrase things a bit differently. When I work with clients at Orcam on designing a portfolio I always try to emphasize that they’re not even “investors”.  Technically, they’re savers and when you treat your portfolio as a “savings portfolio” and not an ”investment portfolio” you tend to align yourself with very different goals than the average “investor” who thinks they have to always beat the market or they’re a loser.

I always say that the two primaries goals of portfolio construction are protecting against purchasing power loss and the risk of permanent loss.  This does NOT mean you have to play the “beat the market” game.  It means you have to generate reasonable risk adjusted returns consistent with the two aforementioned goals.  That’s it.

And most importantly, we’re all active to some degree.  We all need to rebalance, dollar cost average, contribute new funds, reduce portfolio size, pay taxes, etc.  These are all active management techniques of some type. The only thing that’s a truly “passive” approach is a lump sum purchase of a broad aggregate and selling it when you die.  Of course, that has no practical application to our actual portfolios.  So the entire concept of “passive” investing is a nebulous concept sold by people who are trying to differentiate their business models from others.

Perhaps more importantly, most “indexing” strategies are really “indices of indices”.  That is, they’re taking slices of broader indexes and applying a specific allocation based on client needs or other models like Modern Portfolio Theory.  The thing is, none of these portfolios actually represent the passive aggregate of global financial assets.  No one can buy the aggregate of the world’s financial assets and hold it in a truly passive form because that index doesn’t exist.  Not to mention it might not be appropriate for everyone to hold such an allocation.  So when we’re buying “index” funds we’re all taking an index of indexes and allocating it in some manner.  This isn’t passive at all.  It’s a form of active investing that involves an implicit forecast, an explicit allocation choice and an explicit choice of certain index funds.  It might be more passive than day trading, but that is obvious to anyone who’s concerned with portfolios frictions, fees and efficiencies.

The point is, no one owns a truly passive index nor can they nor should they necessarily.  I’m generally in favor of the concepts that stand behind “passive” investing, but it appears to me that this distinction between “active” and “passive” investing is largely a marketing pitch designed to create a misleading distinction.  We can understand the flaws of very active management approaches without portraying them as something they’re not.

The important point is, we are all implementing degrees of active management.  It’s important to understand that foundational point and then work to understand whether some approaches are optimal or not.  Unlike Rick, I think there’s a place in a portfolio for a slightly more active and more sophisticated risk management approach, but we’re mainly on the same page here.




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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  1. Add this warning to the 4 warding signs from Dave Rosenberg. Market is getting frothy on the upside without miuch support from fundamentals, and in contrast to consumer sentiment and tepid consumer spending in December. Wait till we see how the payroll tax increase impacts future consumer spending. This rally’s days are numbered. When it turns, it may turn quite sharply.

  2. Where is the general 10% pull back from these types of runs?
    Won’t happen until after January, then all bets/risk off.

    The retail investor piling in is a BIG sell signal for me.

    Personally, I have not been in this market run up for the last year as I have used my cash positions to reallocate towards brick and mortar job creating small biz locally (Just created another part time position.. YEA!!).

    I do however have a few shekels I can put into the market place in order to start the proverbial 10% correction.

    So every one, just let me know when you want the mkt to drop, and I will take care of it for you. I will just Go Long the Russel or S&P.
    That should get the downward ball rolling.

  3. You will be surprised but the recovering in euro zone might carry US economy in 2013. It’s a global economy. Don’t look just at US consumer sentiment.

  4. So far there is no recovery in the euro zone. In fact things are slowly getting worse, and the stron euro will only compound the problems.

  5. Could it be the impact of the FICA hit to paycheks before it shows up in the high frequency data and gets refelcted in the equity market?

  6. I am NOT surprised. keywords: hihger taxes.
    – Obamacare tax.
    – Higher Social Security tax (back to the 2009 level).
    – State taxes have risen.
    – Deductions will be cut for the income year 2013

    In other words: “Take home pay” was reduced in january 2013. No wonder sentiment is down. When will the markets tank ?

  7. Evidently our deficit spend in Q4 was not large enough to keep the US nose and mouth above the water line. That can be fixed. Print and release.

  8. Michael Schofield….

    It is The Fly, have you never read him before? It is entirely tongue-in-cheek frivolous stuff. Not to be taken seriously.

    Like most online pundits really.

  9. Wouldn’t pay much attention to consumer confidence reports. At best a coincident indicator. Basically, questions to consumers about expectations of future. But they are replying based on today’s economic conditions. Doesn’t tell much going forward.

  10. I don’t know about the meaningless or priced in parts but the market is ignoring the gdp report. Not so bad once you read it. And I’m having some second thoughts about middle class significance. IMO he made some good points wheather he meant to or not. That can be hard to tell with him…fwiw

  11. The incredibly strong Euro is something I don’t understand at all. Just seems that whenever we have “risk on”, the euro seems to go up along with equities. Not sure why. Can anyone please explain this??

  12. A two-track economy might be developing. For the unemployed and underemployed, permanant recession, but government keeps them alive and provides money for necessities and fancy phones). Meanwhile the working economy hums ahead on deficit spending and the global growth path.
    Somebody suggested we have inflation numbers that reflect your station in life — maybe we need to have GDP numbers that do the same.
    For the top 1 percent — asset inflation and easy money means 10 pct GDP growth.
    For the bottom 20 perent — wage deflation means negative growth.
    Revolution to follow.

  13. IMHO, a combination of “reaching for yield” and capital flows as Euro banks pull back from foreign currency lending. There has been a strong wave of institutional buying in Euro bonds after Draghi’s explicit ECB backstop. Institutions need to hit their marks and if Draghi is going to “do whatever it takes” then Euro bonds are an attractive way to get there. Also, Euro banks have been pulling back from foreign lending, which puts a pretty steady bid under the Euro as they reconvert.

  14. “In other words: “Take home pay” was reduced in January 2013. No wonder sentiment is down. When will the markets tank?”

    The strange thing is that many who saw their taxes go up in 2013 were actually shocked their paychecks were lower. Just wait until they get even more taken from them. After all, it was only supposed to happen to the rich. Add to your list higher taxes on businesses – even though businesses don’t really pay taxes, we know who is ultimately affected.