When Is Passive Too Passive?

March 12, 2019 - Max Osbon (4 mins to read)

Regular readers and clients know Osbon Capital Management as an early and continued champion of index investing. Five years ago the distinction between active management and passive indexing was fairly well defined. Passive meant holding a market cap weighted basket of stocks. Active investors practiced stock picking, and some market timing, hoping to avoid the losers and find the winners. Over time that distinction has become far more nuanced. We now see many variations and shades of passive… and clear signs that even for the biggest index fans there is such a thing as being “too passive.”

The True Market Cap Weighting is too passive

Windham Capital Management, local investment powerhouse and close friends of Osbon Capital, regularly publish its estimate of the global world of investable assets. A true market cap weighted portfolio, according to the available global investible assets analyzed by Windham, looks like this:

  • US Stocks: 14.1%
  • Foreign Stocks: 10.1%
  • Emerging Markets: 9.3%
  • US Bonds: 17.2%
  • Foreign Bonds: 26.5%
  • US Property: 3.7%
  • Foreign Property: 8.7%
  • Commodities: 10.5%

Any deviation from the above is, by definition, not a true market cap weighted passive portfolio. Any investor that holds something other than this asset allocation is making choices that are, again by definition, not entirely passive.

In an age when so many people pledge allegiance to passive investing, why doesn’t anyone own a portfolio like the one above? The answer is simple and it has to do with goals.

Three goals

The goal of any investor is a combination of three elements: the store of value, growth and cash flow. For example, real estate investing is often focused on cash flow while tech investing is often focused on growth. Diversification is really just a reminder to focus on investment risks and, ultimately, emphasize store of value.

No investor looking for diversification, store of value, would hold 26.5% of their portfolio in foreign bonds. Additionally, no long-term growth-oriented investor would hold just 14.1% in US Stocks. It’s so blindly passive that it’s a bad fit for almost every investor and goal.

Too few holdings is too passive

Sometimes we hear investors talk about holding just one, two or three passive indexes to manage their portfolio. This looks something like: the S&P 500, plus the default bond index known as the “bond aggregate index (the ‘agg’ for short), plus an international index.

If you own just a few core index positions you can’t change your investments without shaking up the entire portfolio. In addition, known investment factors and themes get unintentionally left out. For instance, energy and utility stocks have different fundamentals from tech stocks. You don’t have to be a stock picker or market timer to take advantage of those differences.

We’ve found the ideal number of holdings to be around 15 or so positions per account. This allows you to spread out your tax basis and retain the option to control your investment themes and exposures. Using multiple holdings helps prevent unintentional exposure. In this case, I’m calling out the default bond index which has become increasingly less attractive over the past year as the bond market continues to fundamentally shift. Not all fixed income is equal and that’s especially true today. (I’m sure I’m going to get a lot of messages next week from active fixed income managers as a result of this paragraph…)

Forgoing small but targeted bets is too passive

Small concentrated stocks open the door for outperformance. Occasionally our clients feel strongly about a particular stock. Because the win/loss % of small high potential bets skews upwards, you can afford to be wrong a handful of times and still come out far ahead. In other words, one stock with a 4x return (+300%) more than makes up for any handful of stocks that lost ~50%. These small concentrated holdings are out of bounds for strict passive investing devotees, but they make sense for certain investors with specific goals. For an interesting read on this topic check out this Bloomberg article from last week discussing an investment research report titled “Even God Would Get Fired as an Active Manager”.

Indexes are actually more active than you might think

Not every company can go public and survive investor scrutiny and regulatory rigor. Furthermore, not every public company can pass the vetting process to be added to a major index. Snapchat and Alibaba are NOT included in the major indexes for seemingly minor but very important reasons. Snapchat due to the lack of voting shares and Alibaba due to Cayman Islands domicile and opaque ownership structure.

Thoughtful investing means focusing on goals, not labels

The vast majority of investors are — rightfully — somewhere in the middle of active vs passive. Investing is an exercise in researching, verifying, being thoughtful, being open-minded and being willing to change your mind. Classic lessons and generally accepted principals will get you most of the way. A willingness to keep an open mind will bring you even further. 10 years ago you could not buy companies based in China, today you can. It’s a different market today – and that will be true 5 years from now as well. The definition of passive will continue to evolve and eventually the terms ‘active’ and ‘passive’ may merge together. What remains will be the continued focus on investing for the store of value, growth and cash flows. These are more important than allegiance to labels.




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