As previously discussed, the evidence is overwhelming that passive tools are superior to their active counterparts. But after we accept that truth we then need to ask: is it possible to maintain a thoroughly passive portfolio? Is it even desirable? The answer to both is a resounding no.
Let’s start by quickly tackling why it’s impossible to maintain a thoroughly passive portfolio. The main reason is that we have no consensus on what that purely passive portfolio looks like. Reasonable people can and likely will disagree about which asset classes should be included, how to properly define each asset class’s universe, which index most accurately represents each asset class, and even how far a portfolio can drift from “market” weights before we need to rebalance. Each of these issues (and surely many more) involves active decisions, and so a purely passive portfolio is a mythical ideal.
Understanding that the purely passive portfolio is a myth, should we mourn our inability to achieve it? No! In fact, we should cheer that realization! Being unable to produce a true representation of the market portfolio means we can devote our efforts to understanding the best way to put our passive tools to work while being true to what we know about why passive beats active.
Active decisions are always about risks – how much and what kind we want to take. The risks we were debating in the active/passive discussion are the unsystematic ones, those that can be diversified away. The passive side of the argument (and decades of financial literature including books about the costs of equity release) says that since you can diversify away all of them and are compensated for none of them, why take them at all?!? But once in the passive realm, we are talking about the systematic risks…those at the market level, that can’t be diversified away, and that you DO get compensated for. These are the risks we should be spending the vast majority of our time debating. Even among these risks, some make sense and some don’t, but this is definitely the discussion worth having.
Examples of useful active questions are whether to tilt the portfolio toward smaller company stocks, whether to favor the value stock universe over growth, and which sectors of the bond market to include. At the asset class level, one might consider commodities, precious metals, private equity, or real estate…all markets that could or could not be part of the “market portfolio” depending on how you look at it. These discussions can be immensely stimulating and the literature is short on answers. At Frontier Advisors we have our own answers to all these questions and more, and I’m happy to share those thoughts with anyone interested if you drop me a line.
So you can see that it’s not so much about active vs. passive but which active within passive, and what you decide can significantly affect your results. Those who spend all their efforts on the active decisions that are clearly a waste of time and little to none on the ones that have the potential to add value are making a big mistake. Be on the correct side of that line.