Passive and Index Investing

Passive or Index Investing

Yesterday I defined active investing and today I am writing about Passive Investing and Index Investing. Since these terms are used interchangeably, I want to discuss both as there are slight differences.  What I don't know is if the broad investing community makes any distinction between passive and index investing. Here is how I view the two investing styles.

Index investing is a subset of Passive Investing, but an extreme form of passive. The Schrodinger Portfolio is about as close as I get to the index investing style.  An index investor will buy a few index funds or index ETFs and then not make any active trading decisions.  In its purest form, index investing is the ultimate in passive investing.

Let me give an example of an index investor.  Suppose this investor wanted to limit their portfolio to no more than five index funds or index ETFs.  This investor wants to diversify into the U.S. Stock Market, International Developed Market, Emerging Markets, Bonds, and REITs.  To cover these five market areas, the index investor might select VTI, VEU, VWO, TIP, and VNQ to cover the five asset classes.  Once the percentages are determined for each asset class, the investor never does anything else other than to rebalance back to the target percentages.  Let me add right here that there are very few investors who go the index route in its pure form.  Most of us will make active portfolio decisions, and that brings me to passive investing.

Passive management is the antithesis of active management, but not as extreme as index management.  The philosophy behind passive management is that one cannot by brains and analysis pick individual stocks to outperform Mr. Market.  The passive manager comes to the conclusion that hard work, technology, etc. cannot, over time and net of fees, result in beating the market.  While a passive manager will use index funds and index ETFs to construct a portfolio, they will make active portfolio decisions.  These decisions differentiate the passive manager from the index manager.  Remember, the index manager is passive to the nth degree.

The passive manager realizes they are not skilled in selecting stocks to fill emerging markets, developed international markets, international REITs, or even value and growth asset classes within the U.S. market.  The active manager thinks they can do it all or else they can select a few stocks that will perform better than the S&P 500, a common benchmark.

An example of a passive manager making a portfolio decision is my current move to reduce the bond allocation and swing toward other equity holdings.  This tactical asset allocation decision is the type a passive manager will make.  The pure index manager would not be making this sort of decision, so I can rule myself out as an index manager.

I have one more investing style to cover, that of Mosaic investing.  I'll save that for a later post.  Before I close today, let me say that I do not have much respect for active investing.  While I recognize there are money managers who are quite successful using the active style, the laws of probability suggest this would also be true if we were all dart throwing monkeys.  I have yet to find any academic paper that will show the consistent advantages of active management.  The stock market is just too efficient to consistently permit the average investor opportunities to capture market "mistakes."  As Rex Sinquefield said, " So who still believes markets don't work? Apparently it is only the North Koreans, the Cubans and the active managers."