What does ‘passive investing’ really mean?

February 20, 2012
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(This article was first published on Portfolio Probe » R language, and kindly contributed to R-bloggers)

We know the words but what do they mean?

Some definitions

Here are some definitions of “passive investment management”.

Investopedia says:

A style of management associated with mutual and exchange-traded funds (ETF) where a fund’s portfolio mirrors a market index.

Wikipedia says:

Passive management (also called passive investing) is a financial strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn’t entail any forecasting

Qfinance says:

the managing of a mutual fund or other investment portfolio by relying on automatic adjustments such as tracking an index instead of making personal judgments.

The Free Dictionary says:

The practice of a money manager or a team of money managers making investment decisions on what securities to include in a fund or portfolio, and then leaving those securities largely unchanged for a significant period of time.

Investorwords says:

An investment strategy that involves buying and holding a portfolio of securities that track the broader market. Index funds are an example of passive investment management, but individual investors who employ a buy and hold strategy use it as well.

My view

I don’t see any of those definitions as really wrong, but I don’t think any are entirely right.  I prefer to think in terms of Figure 1 that considers two dimensions: turnover and effort.

Figure 1: Schematic view of passive versus active management.

The bottom axis is “buy and hold”.  Some people seem to think this is the entirety of “passive”.  At the point (0,0) is the “grandparent portfolio” — the stocks your grandparents gave you when you were a child that you continue to just hold.  This is the ultimate passive portfolio.

Index funds are indicated as having a fairly specific turnover and a range of effort.  The turnover of an index fund is largely determined by the turnover of the index.  The effort depends mostly on how closely the index is tracked.

In contrast, minimum variance is characterized as having a narrow range of effort but a wide range for turnover.  The turnover will depend on how often and stringently rebalancing is done.  The amount of effort for minimum variance is perhaps overstated in the graph.  All you need is some data, a variance estimator and an optimizer (not even a very good one) — you could be up and running in an afternoon.

I divide “passive” into three groups:

  • index funds
  • buy and hold
  • other strategies with low turnover and low effort

Is low volatility investing passive?

By my definition: maybe, maybe not.  Low volatility investing could be done exceeding simply.  Or a volatility screen could be imposed on a very active strategy.

Likewise minimum variance could be used within highly active strategies.  The trade list could be created in a labor-intensive manner, but the weights determined by minimizing variance.

The religion of active versus passive

The discussion of passive versus active includes a great deal of divisiveness: “You have to pick one or the other, and shame on you if you pick the wrong one.”  A lot of this centers on the efficient market model.

I think everyone agrees that it is irrational to believe that markets are efficient and select active management.

One posture that I find interesting is: “If you do not believe in efficient markets, then you must choose active management.”  Why?

The interesting posture on the other side of the fence is: “If you believe in efficient markets, you must use index funds.”  (We’ll skip over the bit about how markets would become efficient if there were no active managers.)  This is another symptom of people believing their models — the index is “the market”.  In reality an index is just someone’s trading strategy that has come to be set in stone.  There are reasons to be concerned about index funds.

I suspect that there are creative ways waiting to be discovered that provide low cost and valuable funds for investors while being profitable for fund managers.

Questions

Are there other dimensions in addition to turnover and effort that should be considered?

Epilogue

Don’t prophesize
I could hold you in my arms
I could hold you forever

from “Hold You in My Arms” by Ray LaMontagne

Appendix R

Figure 1 was drawn in R.  The most useful part is the function that creates the values of an ellipse.  The pp.ellipse function and the function that draws the figure are in ellipse_activepassive.R.

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