Passive Investing Is a Myth

Most people think retail investing has been solved.

Browsing other (worse) blogs, twitter, reddit, investing forums, and other internet locations would certainly give one this impression. Automated investments in a share-dominated passive portfolio is clearly the best option. Apparently it’s the only option…and everyone who doesn’t use this strategy is an idiot.

Sounds great. However, as with most things in life, the seemingly complicated is not actually that complicated and the seemingly simple is not actually that simple, the latter being the phenomenon we see present here.

It’s all well and good deciding to construct a “passive” portfolio but unfortunately this leaves one major question outstanding: what should the composition of this passive portfolio look like? Ultimately, this requires some type of decision of what assets to include and in what quantities. Therefore, no portfolio can be really considered truly “passive”.

Subsets

Consider a simple example. Many claim that one should simply invest in some index of shares determined by geography. “Just invest in the FTSE 100 and get back to work”. Or let’s be even more passive – one can invest in the global market (and get back to work). Beyond the other neglected issues with this approach, what most people don’t seem to realise is that this involves actively making a decision to bet on shares over any other type of asset. There is nothing “passive” about this decision.

One always has to make some sort of decision like this when constructing a portfolio.

An subjective approach

It gets worse: this decision is always in some way subjective. Objectivity doesn’t exist in the complex, mysterious, messy environment that is retail investing.

If one were to select based on some measure of performance, one still has to choose this measure. It’s not clear what to optimise for. Shall we construct a portfolio that reduces the probability of a loss? Or the probability of unfavourable outcomes over our time horizon? Or how about one that has the potential for the highest returns?

There might be an objectively best approach for each individual, factoring in socio-economic situation, goals, personality, etc. If one could accurately identify and communicate all of this information there might be some type of objectively-optimal approach. But this is not possible, so we don’t have to worry about this scenario. Choosing an approach is an active activity.

Subjectivity squared

Just for fun (well, I think it’s fun at least) let’s say your optimal approach was known. Now the question becomes how to translate this approach into the assets one holds.

Imagine we wanted maximum safety. Easy – just hold government bonds.

Unfortunately, again, it’s not clear that this is the best approach. One is highly exposed to the fortunes of that specific government. If default is even a remote possibility, you’ll be in trouble.

A tad more diversification might be a more prudent strategy.

Or consider a strategy to maximise return. Most would go about this by observing the highest-returning assets over the past X number of years and purchasing this collection of assets. 

As I’m sure you’re aware by now, this approach is deeply flawed. There is a reason that growth and value investing tend to slightly out-perform pure passive strategies. As companies perform well – by paying high dividends and increasing in price – more people buy. As more people buy, yield decreases and more demand is required to generate the same percentage increases in price. It’s very hard to be a consistent out-performer, especially when this self-correcting phenomenon is combined with the seemingly-stochastic element of share prices (which results in regression to the mean).

Even if this was a valid method, there are always other assets out there that have probably returned more than those in your portfolio. Why are you not including Kenyan REITs in your portfolio? They have returned 529% over the past 5 years (don’t fact-check that)!

Sharpe’s gambit

The gold standard of performance metrics has historically been returns somehow punished by volatility (see the Sharpe Ratio and other such similar measures). This is probably as close to an objective measure of quality that one can find.

Sharpe Ratio. Source: Investopedia.

Let’s assume that we have identified a collection of assets that will best maximise this ratio of return to volatility over our time horizon but exact performance of each individual asset is unknown.

The question now becomes in what proportion do we invest in these assets. Should we invest everything into the historically-best performer? A weighting based on the probability of performance? I know! Let’s use Modern Portfolio Theory and take historical correlation into account. Please.

In the real world, most are comfortable investing in proportion to market cap, the rationale being that those companies that have performed the best in the past are the most likely to perform the best in the future. I am being generous here – I doubt most “passive” investors have thought about why they do this. This strategy implicitly assumes that those assets that have enjoyed the highest historical returns have the highest expected returns moving forward.

Options

One always has to make several layers of subjective judgement calls when investing. It’s just part of the game. It’s unreasonable to own anywhere near close to even a subset of global publicly traded assets, regardless of what criteria you select. Trying to do so will make you pull your hair out (for those of you who are lucky enough to have some remaining).

However, this is no excuse to outsource decision making by turning to active management.

Like companies eliminating candidates arbitrarily simply to reduce their filtering workload, we can reduce the number of options we have by restricting ourselves to assets available on certain platforms/exchanges, assets that meet certain criteria, employing principles, etc.

Making these subjective decisions is absolutely possible, and encouraged, just don’t kid yourself by claiming you’re a “passive” investor.