3 Tips to Avoid the Active vs Passive Trap

As financial products evolve into increasingly automated and systematic strategies I have begun to notice a big problem – fund managers are increasingly referring to their strategies as “passive”. It’s clear why this is happening – a systematic strategy could arguably be referred to as a passive strategy and passive is synonymous with good. So it’s in the interest of fund companies to avoid being labelled as “active” because then they can call themselves passive and still charge higher fees. But as I’ve noted many times over the years this is a dangerous discussion that can mislead investors if you don’t have a sound understanding of the underlying dynamics.

For example, here’s WealthFront calling their Risk Parity mutual fund “passive”. Risk Parity is a relatively simple strategy. You pick certain asset classes and you weight them by trying to create equal risk exposures between them. For instance, bonds are generally less risky than stocks so a 50/50 stock/bond portfolio isn’t equally weighted in terms of where its risk comes from. So you could leverage your bonds by a certain amount to create greater parity between the two assets. There are a billion different ways to implement such a strategy, but they are all an active deviation from the Global Financial Asset Portfolio. And they will almost certainly result in higher taxes and fees than just buying and holding the GFAP.

Now, this problem is getting worse as time goes by. WealthFront isn’t the first offender and they’re far from the worst. After all, I started noticing this in hedge fund replicating ETF prospectuses after the Financial Crisis and it made my head explode. This view, that we are all active, wasn’t well received at first, but over time more and more people have come around to my view.¹ The problem was, when I started raising a big stink about this issue there was no consistent definition of active vs passive. You might think that passive means low fee and inactive but that can’t  be right because then Warren Buffett is passive and he’s obviously trying to beat the market by picking stocks. Or you might consider any rules based or systematic approach that avoids discretion to be passive, but that can’t be right because then a day trading algorithmic 2&20 hedge fund could be considered passive.

The more I thought about all of this the more I came back to macro-consistent first principles. The only possible “passive” portfolio has to be the Global Financial Asset Portfolio held in the accurate weightings of its current market cap. That is “the market” and anyone who deviates from it is making discretionary decisions that essentially say “the market is wrong”. When viewed thru this lens it becomes obvious that we are all “asset pickers” of some sort. We all necessarily deviate from the GFAP. Some of those deviations are smart (like market cap weighted indexing) and some of those deviations are stupid (like day trading). But the important point is that we are all active and that’s okay within certain parameters.

This is a liberating perspective because it releases us from the misleading marketing attempts that are becoming more prevalent. Instead, when you look at all strategies as active you can begin to objectively analyze those strategies for what they really are instead of being duped into what someone else wants us to think they are.

Make no mistake – this problem is about to get much worse. As more and more systematic funds are launched an increasing number of managers will try to claim their funds are passive when they are indeed active.

So, the important question is, how can we objectively analyze strategies to avoid these marketing gimmicks. Here are a few tips:

1. Always start by assuming every strategy is active. This creates a level playing field and instantly removes the potential that you’ll see “passive” and assume “good”.
2. Always default to “simple is better”. When an asset manager is trying too hard to sell a concept or idea there’s a good chance that they know it doesn’t really work so they have to push it on people.
3. Avoid the alpha chase. Most asset managers know you want to get rich. So they try to sell you the hope of market beating returns in exchange for the guarantee of high fees. But remember that your financial goals have nothing to do with “beating the market” and instead have everything to do with generating an appropriate type of return consistent with your risk profile and future financial needs.

As I said before, this is going to become a bigger and bigger problem over time as fund technology evolves and becomes more systematic. Be careful not to fall for the broad overly general marketing terms that some companies will use to sell their funds. Instead, take a look under the hood and try to understand that strategy for what it really is.

¹ – Funny story – the only website I’ve ever been banned on is the Bogleheads website where I once tried to explain this point. The moderators refused to accept the idea and actually banned me for expressing what is now becoming a widely held view. The craziest point about this is that my view actually reinforces and strengthens the Boglehead view. There’s nothing inconsistent with being a smart low fee diversified indexer and being (marginally) active.