After all the analysis, you still have to decide: active or passive. This post lays out precise reasons that tilt you in one direction or the other — or both.
I said in Post #37 (http://donezra.com/37-active-or-passive-three-separate-issues/) that typically the active/passive issue is discussed as if there’s a right answer and a wrong answer, and it’s your job to find the right answer. That’s unfortunate. The fact is that often it’s best to be partially passive and partially (sometimes necessarily) active (or at least not invest in the passive index). And you ought to understand when each of those choices is most appropriate for you. Let me explain.
As you might guess, I’ve written on the subject. My co-author Dr Geoff Warren and I agreed that the (capitalization-weighted) index for an asset class is the natural default position to start from. What interested us was to identify situations when it makes sense to depart from that default position. We identified three kinds of situations.
The first (call it Reason 1) would be if there isn’t an index that you could replicate in a portfolio. For example, unlisted assets, private equity and real estate (property) are such asset classes. Essentially, you have no choice but to be active. Other relatively illiquid asset classes such as emerging market debt would also qualify.
Reason 2 applies when the weights used in an index aren’t appropriate. Divide this into two parts.
- Reason 2a is when the index conflicts with your purpose. For example, you may want to match drawdowns that are equal over the next five years. No fixed income index matches this series of cash flows. Buying a fixed income index therefore makes no sense; it is sensible, instead, to structure a fixed income portfolio that matches your cash flow needs. Another example is if you have good personal tax-related reasons not to match the index.
- Reason 2b is when you are sufficiently investment savvy to have a well-founded belief that capitalization weighting is inefficient. For example, there are such concepts as equally-weighted and risk-efficient indices that you may believe in as superior constructs. (Or, of course, you may accept your professional’s view on this superiority.)
Reason 3 applies when you believe you can outperform a passive index. This also splits into two parts.
- Reason 3a is the traditional one in which you believe you have superior skill relative to the other skilled investors in the market. This is the one that has been the focal point of the active versus passive debate, the one discussed in Post #39. So I’ll say no more about it.
- Reason 3b is when there’s a reason to believe that active management as a whole may outperform passive management. This needs explanation, since it is generally accepted that active management in the aggregate is necessarily the same thing as a well-constructed passive index, and therefore necessarily underperforms after costs are taken into account.
In fact, that last statement is only true when any departure from the index is construed as active management. But it’s more intuitive to think of active management as being defined as intentionally trying to beat the passive benchmark. And that prompts the obvious question: what other reason could you have for departing from the passive benchmark?
Plenty of reasons, as it happens. Investors have lots of different investment purposes, as I noted in Post #28 (http://donezra.com/28-what-does-spending-money-do-for-you/). In his 2010 book What Investors Really Want (McGraw-Hill Education) Dr Meir Statman noted that investors have three broad purposes: utilitarian, expressive and emotional. The utilitarian purpose is essentially what we’ve been discussing: getting a financial benefit. The expressive purpose is to want the investment to say something about you, such as the egotistical “Look what an exclusive group I belong to, holding this investment,” or (as a more widespread example) “I’m holding this set of investments because I believe strongly in supporting environmental, social and other ethical factors when I invest.” The emotional purpose is when an investment makes you feel good, which might also be true of pursuing environmental and other factors, or just holding an investment for a sentimental reason (like my cousin when he held one share of his favorite soccer team).
So only a subset of investors are genuinely trying to beat the passive index. Their average return may be above or below that of the passive index. And there are many attempts to discover when active (in the sense of deliberately index-competitive) investing may have a tailwind relative to passive. These, then, are times when it may make sense to be active.
Dr Warren and I go into further detail on these angles. Suffice it to say that our conclusion is that, rather than debating the relative merits of active and passive, it seems better to presume that the preferred approach is likely to vary across investors, markets and even time.
Three reasons to depart from passive investing are: (1) It isn’t available. (2) The passive set of investments isn’t consistent with your objective. (3) You really feel you have located active skill.
 Ezra, Don and Geoffrey J. Warren (2010). “When should investors consider an alternative to passive investing?” Journal of Portfolio Management, Vol. 36 No. 4 (Summer 2010).
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.