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When you read the financial press, you will often seeing raging arguments about “active” vs. ” passive” investments. These terms apply to whether or not a mutual fund or exchanged traded fund uses a manager to actively pick from “winners vs losers.” Such funds are “actively managed” and index type funds (in which a sample of securities that fit an index is passively purchased” are considered “passive” investments. The financial literature suggests that paying for active management in large efficient markets like the American stock market does not usually pay.
However, I’d argue that we are all active investors. You (or your advisor) must choose a percentage from zero to 100% for the amount of your portfolio that will hold American stocks (and what size and type?), foreign stocks, bonds, commodities, real estate and other holdings. Unless you are prepared to calculate or research the exact percentages that each of these asset classes exist in terms of global value and then align your portfolio accordingly, you have chosen to make an active choice in allocation. Further active management choices then are ongoing as the initial percentages of each asset choice change over time (they grow or shrink in value). Do you rebalance to the original percentages? Do you decide on a new asset allocation periodically? Do you exclude asset classes that are felt to be overvalued at any given time? In contrast, do you overweight asset classes that appear historically “cheap?” Are trends in world affairs and economics to affect your allocation choices? For example, if you believe that oil will be an increasingly scarce substance, should your portfolio reflect this belief?
Once the not-so-easy choices of asset allocation are made, then the investor/advisor must choose the vehicles for each asset class. Here, we come back to the article’s title, for the evidence is fairly solid that most asset class investments should be put into “passive” index funds. For example, once the decision to put 45% of one’s portfolio into American stocks, most research reveals that the best choice is to buy low cost index funds (or exchange traded funds) that “own” large chunks of the entire American stock index(es). The same goes for most foreign stocks and for bonds-both domestic and foreign. An argument can be made that certain very small markets are best “bought” using active managers who try to pick the best stocks in that particular market, but there is no evidence that this works (although it certainly costs more!).
The seemingly contradictory paragraphs above conflict with a well accepted economic theory known as Efficient Market Theory. This thesis states that markets react instantaneously to economic and other factors that might otherwise allow an investor to gain an advantage. Any conceivable inefficiency is felt to be small enough to not be worth in time and cost to determine. The strong persistence of index fund returns over those actively managed supports the theory and Eugene Fama just won the Nobel Prize in Economics for supporting this theorem.
But adhering to the theory in an orthodox manner may be hard to do (it is for me). There are clearly times that broad asset classes are not efficient, and that the prudent investor can clearly notice extremes of historic valuations. The NASDAQ stocks of the late twentieth century, and real estate securities of 2006-7 seem like clear examples. Ignoring extremes in market behavior seems unwise, and speaks to some degree of active management in making your asset allocation. Robert Shiller just won the Nobel Prize in Economics for this line of thought.
Put these thoughts together and we can agree that the prudent investor uses an active management style to develop and maintain an asset allocation. Then the vehicles used may often be passive to reduce cost and improve performance.