Executive Summary
The debate about which is better - passive versus active investing - has been around for a long time. But in a world of pooled investment vehicles, especially with such a breadth of mutual funds and exchange-traded funds (ETFs), there are technically two levels on which decisions must be made: within the funds, and amongst the funds. Consequently, to describe the approach of an investment advisor, we should ultimately describe the process at both levels, to make clearer distinctions. For instance, are you strategically passive, or would strategically active be a better description. Wait, strategically active? What does THAT mean!?
The inspiration for today's blog post comes from a series of discussions I've been having with several planners, including Ken Solow, the Chief Investment Officer at Pinnacle Advisory Group, about how to classify and characterize various investment approaches that financial planners are using today. Most of the confusion seems to lie in the reality that investment decisions now often occur at two levels - at least where pooled fund investments are concerned - but we rarely make a distinction between the two.
In the "old traditional" world, there were two pretty clear camps: you were either active and bought stocks and bonds (or actively managed mutual funds that bought those things), or you were passive and held index investments (such as mutual funds from a company like Vanguard early on, perhaps an S&P 500 ETF like the SPY from State Street more recently). The line between active and passive was relatively clear.
Now, however, the line isn't as clear. Imagine you are looking at a client's statement from another advisor, and see a broad array of ETF index funds. In the classic world, this client's advisor would 'clearly' be implementing a passive, strategic buy-and-hold investment process. But what if the advisor is actually an active, tactical asset allocator, who is simply implementing the tactical process by making shifts using index ETFs to gain the requisite asset class exposures? The advisor is tactical and active amongst funds, even while the funds themselves are passively constructed. Now you might want to call that tactical asset allocation or you might label it "market timing", but either way it seems clear that a portfolio full of passive index funds doesn't necessarily mean you're purely passive, anymore!
Similarly, some advisors seem to characterize themselves as being strategic buy-and-hold investors who just rebalance periodically... yet the underlying funds they hold may be actively managed mutual funds which themselves change investment holdings. So if your portfolio composition amongst the funds is determined strategically, is bought-and-held, and only altered due to rebalancing, does that mean you're strategic and passive? Or if you buy active funds, does that mean you're still active?
How does all of this get clarified? By classifying an approach at two levels: how the planner invests amongst funds, and how the funds themselves are invested. Thus, one might be tactical with passive funds, tactical with active funds, strategic with passive funds, or strategic with active funds. Four different ways to implement an investment process. Rather than 'just' using the active and passive labels, the description needs to go deeper to capture what happens at both levels: passive versus active holdings, and strategic versus tactical implementation of those holdings.
So what do you think? How would you characterize your investment process? Is this a useful way to make distinctions amongst the ways that portfolios can be implemented?
Michael:
I am not sure if my comment is directly responsive to what you are asking about here. But it relates to the question of whether changes are strategic or tactical and I think it may be at least tangentially relevant. So I am going to take a chance on putting it forward for people’s consideration.
I believe in making strategic changes to the asset allocation for a holding in an index fund. Somehow it became the convention to refer to asset allocation changes for holdings in an index fund as “tactical.” The suggestion is that you are making small, temporary movements in one direction or the other because of a belief that conditions have moved a bit in one direction or the other. But I do not personally believe that such small, temporary changes are worth making. I don’t make tactical changes in my asset allocation. But I strongly believe that strategic changes are needed.
I would define a “strategic” change as one that the investor MUST make if he is to keep his risk profile roughly constant. A regression analysis of the historical data shows that the most likely annualized 10-year return starting from the valuation levels that applied in 1982 is 15 percent real. At the prices that applied in 2000, the most likely 10-year return is a negative 1 percent real. It seems obvious (at least to me) that no investor should be at the same stock allocation in both sets of conditions. So a large asset allocation change is mandatory. The asset allocation change is not tactical in nature, but strategic in nature. It is not engaged in for the purpose of gaining a little edge but is a move that is essential to hopes that the investing plan will work.
These strategic changes are generally long-lasting. If you moved your stock allocation up in 1975, you did not need to lower it until 1996. If you moved your allocation down in 1996, you did not need to increase it all the way through to 2011. But the shifts need to be large ones. An investor whose risk profile called for an 80 percent stock allocation from 1975 through 1995 might best be going with a 20 percent stock allocation from 1996 through today.
Rob
Rob,
I would characterize all of the changes you’re referring to here as tactical, where tactical simply means “making a change to a portfolio based on a forecast, relative to what you would otherwise hold if you held no such forecast.”
The strategic portfolio in that context might better be referred to as the neutral portfolio. It’s what you would hold if you had no forecast (or a forecast that didn’t differ from “neutral”). Shifts from the neutral portfolio become tactical.
The magnitude of the shift is up to you (you advocate big ones). The basis of the forecasts for making the shifts is up to you (you advocate valuation-based). The timing of the shifts is up to you (you imply infrequently here). But I would still characterize all of those changes as tactical.
The key point of differentiation, then, is that in the classic buy-and-hold investing world, the belief is that you can’t forecast {reliably} in the first place, so you don’t. You always hold the neutral portfolio. A belief in being tactical, at the most basic level then, is a belief that in some way, shape, or form, forecasting can be applied in a reliable and effective manner. The timing, magnitude, and basis of those forecasts is still up to you.
Respectfully,
– Michael
I like the distintion you make that I would label “within funds and between funds.” However, we have not cleared up the distinction between active and tactical. Could we sidestep that ambiguity by only using “active.”
The four quadrants would be:
within funds; active or passive
between funds; active or passive.
Laird
Even “within funds” the line is blurring. Are fundamental indexes passive or active? Are mutual funds that are quant rule based active or passive?
Interesting distinction, Michael. Seems useful in a peer-to-peer context.
In fact one can easily imagine the application of a universal standard, with a two-part value ascribed to every advisor. “Hey Jim, nice to meet you. I’m Jonathan with Portico Wealth; we’re a 6-9 on the STAP scale,” STAP standing for ” Strategic-Tactical, Active-Passive.”
However, I think this sort of distinction would be very difficult to impart to clients. Many struggle with the “old” version of active-passive that you refer to above.
SP500, DJ30, RUT2k all passive right? Who decides what goes into these indices? How often do they decide? What criteria? Asset weighted or Equal weighted? Do these indices look the same as they did 5,10,20,30 years ago? Do we now have indices we didn’t have 30 years ago? Why? On another note, a recent article compares what would have happened if Apple had been inducted into the Dow30 instead of Cisco. This all seems “active” to me. Maybe we need better definitions for “active” & “passive”. Is it maybe that the appeal of indexing/passive management is that it’s low turnover, rather than no turnover? If so, where is the textbook definition or delineation of “low”? Is it appropriate to sell Enron before it goes to zero? Why does Warren Buffet promote indexing and decry shadow-market vehicles, yet does not index and uses futures, swaps, etc? Why does Vanguard offer non-index funds if they believe so strongly in indexing? Why does Fidelity offer cheaper index funds than Vanguard?
To answer your final question – my passive models using active funds outperform my passive/passive models by quite a bit. Statistically speaking that should not be possible, but there it is in black and white (or solid green?).
Final question: is it unethical you yell “Movie” in a crowded firehouse?