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No investor is fully passive

John Rekenthaler  |  29 Jun 2017Text size  Decrease  Increase  |  
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When it comes to portfolio formation, as opposed to security selection, there are no saints among us, says Morningstar's John Rekenthaler.


Hidden activity

James Stewart recently wrote that long-time index fund proponent Burton Malkiel had switched sides. Joining robo-advisor Wealthfront, claimed Stewart, made Malkiel an active investor. (The article's headline went one step further, accusing Malkiel of "straying from his gospel.")

Yes, Wealthfront praises the merits of passive investing, but let's not kid ourselves--in Stewart's words, "the strategy aims to exploit market inefficiencies and beat the passive approach".

I agree with Stewart that Malkiel has switched--or at least modified--his position on security selection. He once advocated investing solely according to the investment's size, that is, according to its market capitalisation. Today, he suggests improvement on that.

However, I would extend the argument in a fashion that softens that criticism: When it comes to portfolio formation, as opposed to security selection, everybody is active. There are no saints among us. Every portfolio reflects a situation and viewpoint. There is no natural landing point, shared by all who are purely passive.

Well, there is one portfolio, but it can't be achieved. That is the collection of assets that forms the globe's entire wealth. All stock markets, all fixed-income securities, all private companies, all real estate, all commodities, all collectibles ... anything that carries value.

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Somebody who holds a proportionate sliver of that agglomeration, which I will term the "Global Wealth Index" (GWI), is indeed passive.

Nobody does, of course, nor is likely to for a long time (if ever).

Beneath the water

Thus, the first active decision is whether to attempt to compensate for the GWI's shortfall by garnering exposure to wealth that it fails to capture. Largely, university endowment funds do just that.

They hold private-equity and venture-capital funds for exposure to non-public companies; directly held positions in real estate; hedge funds that may own illiquid assets; and commodities. They invest in those items unscientifically and actively, but paradoxically that activity brings them closer to the GWI.

Retail investors generally don't bother to pursue the hidden asset classes, aside from owning their homes, which gives them a highly idiosyncratic and often-unrepresentative slice of the world's real estate market.

It is not, I think, that most investors are opposed to owning wealth in forms other than stocks, bonds, and cash. Rather, they are reluctant because most of the useful, cost-effective ways of getting exposure to these other assets are available only to institutions.

The taxman cometh

The next active decision is taxes. To take a locally based example, the Global Wealth Index contains an asset class, US municipal bonds, that offers a tax benefit that is useless outside the United States, and inside the US for tax-sheltered accounts.

Fairly obviously, that single Global Wealth Index needs to be offered in different tax flavours, to suit each investor's location and tax status.

That, perhaps, does not constitute "active" investing; it is instead reorganising one index into multiple indexes. However, the next step certainly is active, which is deciding for taxable accounts whether to follow the index's market-capitalised weightings, or to deviate for tax reasons.

Should investors in a high tax bracket own fewer junk bonds and more low-dividend growth stocks? That question cannot easily be addressed ... in short, its answer is "maybe," and the analysis is active.

Risks, locale, and currencies

The third active decision is risk. Once again, it is possible to reconfigure the Global Wealth Portfolio into many portfolios, which would range the spectrum from the safest (presumably, cash and inflation-adjusted bonds) to the highest risk. Once again, that could be called index manipulation, not an investor's active decision.

Somehow, though, the investor must settle on one of these risk portfolios--and that process is a form of active management. Risk assessment is informed by numbers, but it is not determined solely by algorithms. (Or, if it is, the creation of those algorithms was an active event.)

Then comes the question of whether to invest more heavily in one's home country. The Global Wealth Index cares not where we live. But perhaps it should. I have little sympathy for the claim that investors are happiest when they invest in what they know, so they should stay close to home.

That might make psychological sense--as opposed to investment sense, which it definitely does not--for those who pick stocks. (Might.) It doesn't much for a broadly diversified index fund. However, there's something to the argument that if US investors have US liabilities, that they might wish to offset them by holding US assets.

This subject, too, cannot be settled by science. Many have tried, penning articles that purport to find the chair that comfortably seats Goldilocks--not too much home bias, but not so little that the assets are perhaps too mismatched with the liabilities.

None of those efforts convince, in part because different investors have different liabilities, and in part because measuring the damage caused by one theoretical drawback (the loss of diversification that comes from home-country bias) against another (asset-liability mismatches) requires judgment.

Finally, there is the related item of currency exposure. This is a smaller problem for American investors than for those in other countries, because so much of the Global Wealth Index is denominated in dollars. Very roughly speaking, half of the world's traded stocks and bonds are dollar-based, and commodities commonly are priced as such, too.

Nonetheless, the question remains: Optimally, how much in foreign currencies should US investors own, and would the Global Wealth Index's proportion be close to that figure?

This, I recognise, has been largely a hypothetical discussion. There is no Global Wealth Index against which to measure one's choices--to determine what active bets were made, and why. The column's point, I hope, is more tangible.

It is that all purportedly "passive" portfolios--whether asset-allocation funds, ETF managed portfolios, or simply a collection of index funds that an investor has assembled--have incorporated several active decisions.

If the underlying funds are indexes, based on market capitalisation, then the components may fairly be called passive. But the outcome cannot.

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John Rekenthaler is Morningstar's US-based vice president of research and has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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