There’s a growing problem in DIY investing. While passive investing is terrific (and a pillar of The Best Interest), there’s more to passive investing than meets the eye.
The problem I want to highlight today is the investor who thinks, “I’m all passive, therefore I’m all set.”
That’s risky thinking. Not all passive portfolios are built the same. While some genuinely reflect global investment markets, others are dangerously concentrated. Many investors are blissfully unaware of their investments’ concentrations and might not realize their mistakes until after a nasty streak of underperformance.
Basic Definitions: Passive vs. Active
For those unfamiliar, the basic definitions of passive and active investing are:
Passive investing seeks to replicate the performance of a specific market index (e.g. the S&P 500, or Barclay’s Aggregate Bond Index) by owning a proportional share of the securities (stocks, bonds, etc.) included in the targeted index.
Since passive investing involves minimal management decisions, passive fees are typically lower than those of actively managed funds. The end goal of passive investing is to match the returns of the chosen market index rather than outperform it.
Active investing involves buying and selling securities to outperform the market or a benchmark index. Since active investing requires more management, research effort, and trading activity, the associated fees are generally higher than passive fees.
Active investing strategies are judged not only by “beating the market,” but by doing so in excess of their fees.
However, simple mathematical logic shows us how challenging this is. We expect the sum of all active investing strategies to perform in lockstep with the index (a.k.a. the market average). But then those active investing strategies charge a higher fee. Thus, most active investors underperform the market by the magnitude of their fees.
Thus, passive investing tends to outperform active investing over long periods, simply as a function of different fees. This is a pillar of The Best Interest’s long-term investing philosophies.
Passive Doesn’t Necessitate “Good”
While “passive” is usually better than “active,” that doesn’t mean that all passive investing is inherently “good.”
Too often, DIY investors make mistakes thinking that their passive investment strategy is good simply because it’s passive. While many good investing strategies include passive investments, not all passive investments equate to good investment strategies.
For example, QQQ is a passive index fund that tracks the Nasdaq 100 index. It’s a massive fund, with over $260 billion in investor dollars, making it the 5th largest ETF (exchange-traded fund) on the market.
Can QQQ be part of a sound investing strategy? Absolutely.
But is QQQ alone a sound investing strategy? No way.
QQQ is far too concentrated to be a standalone investing strategy. 60% of the fund is concentrated in the Technology sector. 99% of the fund companies are U.S.-domiciled. Having 100% of your investment dollars in QQQ would ignore far too much of the investment universe.
Despite being passive, QQQ is too concentrated and thus too risky to be a standalone long-term investing strategy.
What Investors Actually Want: Low Fees and Diversification
Long-term investors want diversification and low fees. Ideally, our portfolios diversify across geographies, sectors/industries, company sizes, asset classes, tax treatments, and more.
Passive investments that track diverse indices are, by definition, a terrific solution to meet these needs.
Take VTWAX, for example. It’s Vanguard’s Total World Stock Index Fund. VTWAX aims to own all publicly traded stocks in the world in proportion to their sizes. By its nature, VTWAX diversifies across sectors and industries, geographies, etc. It provides a reasonable “one-stop shop” to fill a long-term investor’s stock allocation in their portfolio (in a way that QQQ is far too concentrated to do).
A passive investment can undoubtedly be the solution if you want diversification and low fees. But that doesn’t mean that all passive investments answer that call. It’s a nuanced difference.
Active Allocation Decisions
We also need to differentiate between the investments we own and the decisions we make. You can own all passive funds yet have a portfolio with active allocation decisions. There’s nothing inherently wrong with those active allocation decisions, so long as the investor knows them (and how they will affect their portfolio performance).
Take, for example, a 60% stock + 40% bond portfolio. First things first – why did the investor choose those percentages?
Are they following an age-based bond rule? Are they “bucketing” their money for goals-based investing? Did they read about “60/40” portfolios on The Best Interest and assume it was right for them? Why not 70/30, or 80/20, or 50/50?
They could own all passive funds in their 60/40 portfolio. Still, the proportions of those funds (aka the asset allocation) is an active decision that has a considerable impact on their portfolio performance.
Not owning real estate, precious metals, or cryptocurrency is an active decision. That doesn’t mean is a bad decision, though! We must differentiate between “good/bad” and “passive/active.”
Tilting At Windmills…
What about when investors decide to “tilt” their portfolios? A portfolio tilt refers to a deliberate deviation from a neutral investment allocation. It involves adjusting the asset allocation slightly to overemphasize specific sectors, asset classes, or investment styles while underweighting or avoiding others.
Common tilts include tilting toward small-cap companies, value stocks, or momentum stocks. Almost all common tilts can be implemented with passive funds designed explicitly for those tilt factors (e.g. VXIAX is a passive, large-cap value fund).
Of course, the decision to tilt a portfolio is active. As a result of these tilts, the portfolio will over- or under-perform the index. It’s as hands-on, finger-in-the-pie as it comes! Yet all of the funds themselves are still passive! Passive funds do not always equate to a passive portfolio.
The only true passive portfolio would own all investable assets in proportion to how those assets comprise the entire global investment world. Creating that passive portfolio would be a tall task; I wouldn’t know where to start. How am I going to invest in New Zealand wool futures?
Every other portfolio – including mine and yours – is some shade of gray between “true passive” and “completely active.”
- If your stock portfolio is 99% VTWAX + 1% QQQ (because you want to tilt your portfolio towards American tech), you’re still mainly replicating the global stock market.
- If you’re 50% VTWAX + 50% QQQ, you’re now vastly overweight to American tech. A completely different shade of gray.
There’s nothing wrong with making active portfolio decisions as long as the investor is aware of their overweights and underweights.
How Passive Are You?
The big takeaway today: take a hard look at your asset allocation and answer the following questions:
- Do you own all passive funds? If you own active funds, do you understand their role in your portfolio?
- Why do you own the asset classes (stocks, bonds, etc.) that you own?
- Are you diversified across geographies? Why or why not?
- Repeat that question for sectors/industries and company sizes (large cap, small cap, etc).
- Do you have any tilts in your portfolio? Why or why not?
Better yet, take your answers to these questions and contemplate how those answers affect your future performance. Specifically, how your performance is likely to deviate from the typical indices (S&P 500, Russell 2000, MSCI, Barclay’s Agg, etc).
Know what you own, why you own it, and how it will affect your portfolio’s future. I encourage owning passive funds in a mostly passive manner but taking an incredibly active role in understanding why!
Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
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