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Editor's Letter: March 2017

The line blurs between active and passive.

Wesley Gray, the CEO of Alpha Architect, is a great resource for demystifying the arcane world of asset management. Following his writings on the Alpha Architect site has, for me, been an education.

So, I was paying attention when he recently took the financial press to task for not really understanding the difference between passive and active investment management. According to him, those of us outside the professional zone of asset managers wrongly consider “active” investment funds to be only those where the portfolio is decided by a human manager sniffing through 10-Ks, interviewing management teams, and relying on his or her gut instinct. Anything other than that is “passive.”

Instead, he points out true passive management is simply a portfolio that mimics—in weight and composition—any given market (or a market proxy, like the S&P 500). Meaning, if a stock makes up 3 percent of the value of the market, it is 3 percent of the investor’s portfolio. Everything else it seems falls under the broad rubric of active, even if it's via a systematic and automated portfolio selection untouched by human discretion.

Consider, for example, factor-based investing or “smart beta” funds. Active or passive? Most investors would likely consider them passive funds: There is no discretionary buying and selling in the portfolio; the portfolio is what it is, according to the criteria to which it adheres. The decisions might be based on valuation metrics, size of the company, its price momentum, etc., and in that way they do deviate from being a replica of the market as a whole. Therefore, in the minds of CFAs, these funds are active.

But what about investing in a fund that tracks the Dow Jones Index? 30 stocks...can 30 stocks be a proxy for the market, therefore a passive strategy? Picking a mere 30 stocks, by any criteria, seems to be an active act of investment management to me. A human decides on an index—they aren’t handed down by the gods. Stocks fall in and out of that index, leading the funds to buy and sell those companies. Seems pretty active. Yet, investment advisors tell clients their core portfolio positions should be passive funds that follow a benchmark somewhere inside the Morningstar style box, i.e., large-cap growth or value funds. According to the CFAs, this is an active approach.

Gray suggests the confusion escalated with the rise of exchange traded funds, which must file with the SEC under an exemptive relief from existing securities laws. That relief is designated as either active or "index," depending on whether the fund sponsors systematically follow a process (index) or choose to either follow a process and/or invest based on discretion (active). Down the rabbit hole we go.

The nomenclature is important and investors should be forgiven for having a distrust of financial services firms’ jargon, of which there is no shortage. (To be clear, this is not what Gray is doing. The attempt to demystify the financial jargon is one reason I respect his writing.)

It’s important because active management has been demonized in the minds of investors. To suggest a fund is “actively managed” is to taint it with suspicion. (Aren’t we continually told that active funds don’t outperform?)

This may be a big ask, but maybe we stop drawing a line between active and passive, and stop demonizing active managers. Costs are really the big differentiator in performance. Go active, but keep it cheap. It’s more than doable given the rise of ETFs and factor-based funds.

Would love to get your thoughts - [email protected].

David Armstrong


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