Passive Investing Doesn’t Exist, But So What?

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Rick Ferri
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Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

I wrote the book, The Power of Passive Investing, so you’d expect me to be the last person to say there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist. Passive investors shouldn’t let this get in their way.

Passive Investing Doesn’t Exist, But So What?

Rick Ferri


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Last edited by Rick Ferri on Mon Mar 11, 2013 11:16 am, edited 1 time in total.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by pkcrafter »

Ooooh, Boy, is this one going to be a can of worms. :shock:


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Re: Passive Investing Doesn’t Exist, But So What?

Post by dkturner »

Rick Ferri wrote:I wrote the book, The Power of Passive Investing, so you’d expect me to be the last person to say there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist. Passive investors shouldn’t let this get in their way.

Passive Investing Doesn’t Exist, But So What?

Rick Ferri


.

You mean I've been in the majority all along?
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

Active and passive is in the eyes of the investor. What's active to one person is passive to another. It's all relative - and just semantics. Your line in the sand may be cost, it may be turnover, it may be intent. I know where my line is, and that's why I can write a passive investing book.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by BornInCA »

Well, what is "passive"? Is adding money to a mutual fund on a regular basis (weekly, bi-weekly, monthly, quarterly, etc.) "active" or "passive"?

Here's why it can be called "passive" -- For a particular mutual fund, the investor sets a fixed schedule where both the dollar amount is fixed and the timing is fixed. Once the investment firm approves of it and puts it in place, he/she doesn't need to do anything more. Just sit back and RELAX!!! :happy

Here's why it can be called "active" -- Because money is pouring into the mutual fund frequently. There is "activity" going on with the mutual fund. The investor is purchasing shares all the time. :|
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Taylor Larimore »

Hi Rick:

Just when I think I understand, you come up with a new concept I never thought about ("Passive Investing Doesn't Exist").

Thank you and best wishes.

Best wishes.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

It's all a question of degree, Taylor. It's not where others draw the line, it's where YOU draw the line. :D
BornInCA wrote:Well, what is "passive"? Is adding money to a mutual fund on a regular basis (weekly, bi-weekly, monthly, quarterly, etc.) "active" or "passive"?
The decision to do it either weekly, bi-weekly, monthly etc is also an active one. Why monthly and not weekly, why weekly and not quarterly? This decision will affect your return, we don't know how, but it will. What about rebalancing? Should you do it annually, quarterly, never, using bands? It's a active decision.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by EDN »

Fama Jr. covered this ground better almost 15 years ago than anyone I've seen since. I reposted the article here:

http://www.bogleheads.org/forum/viewtop ... 0&t=112646

I simply cannot understand this fascination with labels: is it passive or enhanced or active indexing or intelligent indexing?

Either you think "markets work" and are trying to capture the expected returns imbedded in markets as efficiently as you can, or...

You think they don't, and therefore are trying to exploit the mispricings in markets. I think its pretty black and white.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by Allan Roth »

But we can let experts, like the ones at Vanguard, decide "active" things like how to buy Facebook once it becomes public and part of the index. I agree that this is technically active but I also agree "so what?"
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Re: Passive Investing Doesn’t Exist, But So What?

Post by stingray5688 »

So choosing to be passive is actually active.

Reminds me of Rush - "If you choose not to decide, you still have made a choice."
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

EDN wrote:I simply cannot understand this fascination with labels: is it passive or enhanced or active indexing or intelligent indexing? Either you think "markets work" and are trying to capture the expected returns imbedded in markets as efficiently as you can, or...You think they don't, and therefore are trying to exploit the mispricings in markets. I think its pretty black and white.

Eric
Yet many academics believe that the value premium is a result of mispricing, not risk. If they are even half right, and I think they are, this makes value investing an active management strategy.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by Fallible »

I never thought of passive in the purest sense, but just as a term relative to "active." As you say, "When the goal is to be the market rather than beat the market, that’s passive in my book." It is in my book, too.

In fact, "passive" to me seems similar to "staying the course" or "buy and hold," where some take the terms literally, i.e., to do absolutely nothing, which of course is not at all the case.

Thanks for the column!
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Re: Passive Investing Doesn’t Exist, But So What?

Post by BornInCA »

Rick Ferri wrote:It's all a question of degree, Taylor. It's not where others draw the line, it's where YOU draw the line. :D
BornInCA wrote:Well, what is "passive"? Is adding money to a mutual fund on a regular basis (weekly, bi-weekly, monthly, quarterly, etc.) "active" or "passive"?
The decision to do it either weekly, bi-weekly, monthly etc is also an active one. Why monthly and not weekly, why weekly and not quarterly? This decision will affect your return, we don't know how, but it will. What about rebalancing? Should you do it annually, quarterly, never, using bands? It's a active decision.

Rick Ferri
I agree with everything in the quotes there. Here is a distinction I make for myself. Let's say I decide to invest $100 in XYZ Fund every two weeks. There are 2 methods to do this:

1.) Log in to my investment account every two weeks and make a "buy" transaction into the fund.
2.) In my investment account, set up an automation process where $100 will be invested every 2 weeks. This can be done through payroll deduction or electronic debit from my bank account.

If I do the first method, I would call myself "active" because I am required "to act" or "to take action" every 2 weeks. If I do the second method, the only action I'm taking is setting up the automation process. There is no further action I need to take until I change my mind.

I guess I'd call myself "passive" until I change my mind. ;)
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Re: Passive Investing Doesn’t Exist, But So What?

Post by maj »

Mr. Ferri's article is, I find, correct reasoning and analysis.
Moreover, it is the explanation of why I use balanced index funds, namely, LifeStrategy Growth Fund (even better now that Short Term Bond Fund and Asset Allocation Fund have been removed).

First, I acknowledge there is no perfect investment plan for me (or anyone else, I suspect).

Second, I acknowledge there are minor tax consequences in my use of the balanced index fund in my taxable account.
However, here's what I get for .17 basis points per annum:
1. Automatic rebalancing every day the market is open: a relaible 56% in Total USA stock market, a reliable 24% in Total International stock market, a reliable 20% in Total USA bond market.
2. I pay a bit more in taxes for the bond portion of the dividends but, wonderfully, I protect myself from a significant amount of speculative froth by holding 20% in bonds--and I have enjoyed this protection since 01/02/1995, 4 months after LS funds opened. The froth was scooped off the stocks in 2000 and 2007 in particular.
3. Since I am a buy and hold and rebalance investor, I do not need to decide when to remove the froth or to reenter the market--Vanguard index managers 'actively' do those chores for me daily even though I suspect they are underpaid by standards of Wall Street.

I do not oppose active management (I hold Wellington and Wellesley in my tax-deferred accounts along with LS Growth).

I simply believe that the 'active' management Mr Ferri describes in detail is something I do not want to do, I do not know how to do well without incurring burdensome capital gains--short and long term, and I believe there are millions of investors like I who receive, for 17 basis points, services which would cost at least 1-2% from a financial advisor or trustee.

I can buy a bond fund or CDs as I grow older to reduce my equity exposure.

Thanks, Mr. Ferri, for exposing indexing for what it is--a free lunch!!!

peace
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Re: Passive Investing Doesn’t Exist, But So What?

Post by LadyGeek »

Allan Roth wrote:But we can let experts, like the ones at Vanguard, decide "active" things like how to buy Facebook once it becomes public and part of the index. I agree that this is technically active but I also agree "so what?"
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Dandy »

Somewhat dangerous to lump indexing with active management. A minor point about index managers having to take action to properly represent the market/index is hardly the same as a portfolio manger or "team" trading on a daily basis because they think they can beat the market or know where the market, interest rates, economy etc is going to be.

It is similar to calling a person who rebalances his portfolio according to his IPS a market timer as opposed to a risk maintainer. Vast difference. If I make a trade today am I a day trader??

This idea will just give active managers the argument "see even some dedicated index proponents are active mangagers"

I guess there was some Ah ha moment for Rick but I don't see it.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

No Ah ha moment here as I explained in the article. When someone says rebalancing as market-timing, I say no, it's risk control. If they disagree, that's there opinion. There are no laws about which it is.

Even the SEC gives a pass to "index" provider's whose methods are complex quantitative structures, hold few securities and have high turnover. The ETF companies that follow these indexes can claim their funds are "passive" investments because they follow indexes. Put is all together and the SEC lets pass that quantitative management is passive indexing. Go figure.

We make our own choices about what's active and passive. We draw our own lines in the sand. That's what the article is about.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by umfundi »

Seems to me, there is a bubble in active vs. passive discussions.

Active is the new passive, therefore active works? :P

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Re: Passive Investing Doesn’t Exist, But So What?

Post by Matigas »

Has to be true, since you are the expert. I like your idea though, it matters not what you think, or what I think, it only matters what we do, and even then our actions can never be PROVEN to affect an outcome.

Albert Camus would be proud.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by LH »

Column deadline?

:P
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Re: Passive Investing Doesn’t Exist, But So What?

Post by dkturner »

In further support of Rick's point about indexing being active management, has anyone ever noticed the following excerpt from the prospectus for Vanguard's bond index funds?

"Each Fund will invest at least 80% of its assets in bonds held in its target index. Up to
20% of each Fund’s assets may be used to purchase nonpublic, investment-grade
securities, generally referred to as 144A securities, as well as smaller public issues or
medium-term notes not included in the index because of the small size of the issue."

As far as I'm aware that languge has been in the prospectus since the inception of these funds. Any oldtimers remember what happened to the these bond index funds in 2002?
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Akiva »

Rick Ferri wrote:I wrote the book, The Power of Passive Investing, so you’d expect me to be the last person to say there’s no such thing as passive investing. It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist. Passive investors shouldn’t let this get in their way.

Passive Investing Doesn’t Exist, But So What?

Rick Ferri


.
I generally concur with the article. I'd also add that over time there's been a gradual "drift" in what sorts of things were considered passive. A while back, over-weighting small caps and value stocks to try and capture their historic excess returns would have been considered "active". Now people generally buy the "risk factor" theory (though I think the evidence is still out on this one) and consequently they think that tilting like this is "passive". Until a couple of years ago, there were no index-like funds that tried to exploit the low-beta/low-volatility phenomena, but now that there are such funds, it seems that capturing this could arguably count as "passive". OTOH, while momentum is a long-standing well documented anomaly, there is still no easy to way track it and consequently most people don't consider it "passive", but if someone comes up with a cost-effective fund that does track that factor, then people will probably reassess things.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

If the value premium is a risk story, then trying to capture this risk with a value weighted strategy could be considered passive. However, if it's a behavioral story, then value investing is an active strategy. In fact, it's probably some of both, which makes value investing active management.

I'm giving away too much of my next article so I'll stop here.

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Re: Passive Investing Doesn’t Exist, But So What?

Post by Random Musings »

At this point, I might as well start trading solely in options.

If we're all active, I'll goin' full tilt and no pussyfooting. :twisted:

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Re: Passive Investing Doesn’t Exist, But So What?

Post by SamB »

I agree completely with this. What is pushed on this forum is just a technique for extracting the market return with 100% certainty minus the costs. It is not passive, but an active technique, both in terms of the mutual fund management and the asset allocation and risk profile sought by the investor.

The simple concept of managing your risk by having your age expressed as a percentage in bonds is an active technique. In fact, the term "passive" is very misleading.
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Re: Passive Investing Doesn’t Exist, But So What?

Post by EDN »

Ah yes, the "is it risk or free-lunch" debate. Another "if a tree falls in the woods" rhetorical question.

It seems to me that before we start writing off a value approach as a safer version of investing -- at least value in terms of how it is defined in the Fama/French and asset pricing community's research -- we should make some attempt to explain two simple issues:

1. why the higher cost of capital of these value companies (as we can see from the fact that Vanguard HY Bond Fund is made of up fixed income securities from predominate value companies) does not lead us to an appreciation of higher risk and expected return as it would in any other case?

2. why, if it is a behavioral phenomenon that is exploitable by those who can apply these "market-error" models, then active value funds underperform a well managed, structured value fund that just holds the cheapest 20% of stocks based on price to book by far more than the expense differential, OR better yet, why the founding fathers of the behavioralist movement themselves, Lakonishok, Shleifer, and Vishny (LSV) have been unable to beat this same structured value fund with their LSV Equity fund that, one would assume, applies the absolute best advancements in behavioral investing to produce excess returns relative to the value universe as a whole (not the S&P 500, as some would have us compare to).

Anyway, even if you don't see it this way, I would propose that you should still act as if value is a risk story anyway. Why? Well, lets say you don't, and load up on value for a "free-lunch", and the risk shows up...you aren't likely to stick around to get the reward having your inefficient expectations dashed. On the other hand, lets say you think its a risk story, but the risk doesn't show up during your horizon -- doesn't make it a mistake. No one laments the fire escape routes printed in their hotel rooms even if the building doesn't catch fire the night you sty there, do they?

As someone who counseled clients through 2007/2008 with quite a bit of LV, SV, ILV, ISV, and EMV (along with S&P 500 in many cases) on the stock side and lived (prospered) to tell about it without making allocation changes, I'm saying that taking the "risk route" is a much better path in terms of expectations and realizing the potential (good/bad) of your plan. I'd strongly suggest readers take a similar tack.

Eric
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Re: Passive Investing Doesn’t Exist, But So What?

Post by Rick Ferri »

Eric

1) My artcle on Thursday will be about style investing and if it is an active or passive strategy.
2) I agree that it really does not matter. If you're sold on the strategy, then just do it.

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