Active Versus Passive Investing: Can we End the Confusion?

/Active Versus Passive Investing: Can we End the Confusion?

Active Versus Passive Investing: Can we End the Confusion?

I’ve noticed something profound the past few years: depending on your audience, the definition of active investing and passive investing is different.

To a financial journalist, active means “human stock-picker,” and passive means “computer stock-picker.” In addition, financial journalists often consider that index and passive mean the same thing, because both strategies rely on a “computer stock picker.”

An example of this interpretation of the terms active and passive was highlighted recently in a Barron’s article, which describes our firm’s recent switch from operating our ETFs under an active relief, to operating our ETFs under index relief:

Well if you can’t beat ‘em, join ‘em. That’s what Alpha Architect is doing with four of its actively managed ETFs flipping the switch and going passive.

Further in the article, the writer highlights the interpretation that active = human stock-picker and passive = index = computer stock-picker:

…the funds…weren’t all that active to begin with. The firm uses quantitative strategies based on academic research, so a manager wasn’t making portfolio changes on a whim every morning.

Now, to be clear, there is nothing inherently wrong with the press’s use of the terms “active,” “passive,” and “index.” These are just words and nobody could — or should — get to serve as the Speech Police.  However, in this piece I would like to highlight that how the press uses the terms active/passive is completely different than how the finance profession uses the same terms: a financial professional’s interpretation of the terms active and passive are very different and the term index is ambiguous because an index can be highly active or passive.

In fact, when it comes to understanding the words active and passive it’s almost as if some people see the duck in the image below, but others see the rabbit:

 

duck or rabbit

Duck or Rabbit? Hint: turn your head to the left and remember that the duck bill is the bunny’s ears

Finance professionals and the financial press are looking at the same picture, but they are interpreting the information in completely different ways. The problem with this communication logjam is that it can cause immense confusion among the investing public (we’ll explain why later in this post).(1)

The Financial Definition of Active and Passive Investing

For anybody who has ever studied finance, the definitions for active and passive are well-established (a shortened version of Bill Sharpe’s definition from the Arithmetic of Active Management is below:(2)

  • Passive = Value-weighted index of all assets in a given market (e.g., the US stock market, often proxied by the S&P 500, or even more accurately proxied via the Wilshire 5000).(3)
  • Active = Not passive.
    • On one extreme, an active portfolio might hold a single position in stock ABC. On the other extreme, an active fund might hold 490 out of ~500 stocks from the S&P 500. Both portfolios are active to varying degrees(4), but one thing is clear: they aren’t passive.
    • Alpha Architect believes active can be useful if investors are sustainable.

We should also highlight the two investment approaches a fund manager can utilize to “pick their stocks:”

  • Systematic or Index-Based or Computer Stock-Picker = Stock picking with a model or system.
    • There is typically minimal human decision-making involved once the process is established (e.g., “quants”, “smart beta”, “high-frequency-trading”, and so forth).
    • Alpha Architect believes in this approach and this approach is driving the ETF industry.
  • Discretionary or Human Stock-Picker = Stock picking based on human intuition, analysis, and synthesis (e.g., Warren Buffett, Peter Lynch, Julian Robertson, my dad, etc.).
    • Some firms believe in this approach, and it is often associated with famous investors such as Bill Ackman, Dan Loeb, Leon Cooperman, and David Einhorn.

With these definitions in hand, we can categorize most investment approaches into the following taxonomy:(5)

  • Active Index — computer-driven stock-picking that deviates from the passive approach.
  • Active Discretionary — human-driven stock-picking that deviates from a passive approach.
  • Passive Index — passive portfolios that, by construction, are systematic and computer-driven.(6)

active index and passive index

Please note that the terms active and passive have nothing to do with who implements the strategy (i.e., a computer or a human being), but have everything to do with the construction of the portfolio (i.e., deviates from market-cap weighting of all assets in a market or does not).

Interchangeably using the terms “passive” and “index” is ambiguous and confusing, unless one describes the term “index” as either a “passive index” or an “active index.”

This is finance 101 stuff and I’m sure regular blog readers are all bored out of our minds at this point…

What are the Alternative Definitions of Active and Passive?

As was alluded to earlier, for the non-finance jargon crowd (e.g., financial press, lawyers, etc.), active and passive mean something very different:

  • Passive_nonfinance = Systematic or Index-Based or Computer Stock-Picker (e.g., quants smoking cigarettes with their computers like Jim Simons).
    • Unlike the finance definition of passive, passive_nonfinance means a computer “passively” selects securities.
    • Example: Jim Simons, the uber-quant hedge fund manager, would be deemed a passive investor to a non-finance person. However, to a finance-jargon person, Jim Simons is clearly an active systematic/index/model investor.
Simons

Jim Simons, former head of RenTech: “Passive” according to the press and lawyers because his stock selection is based on a systematic process driven by computers.

  • Active_nonfinance = Discretionary or human stock-picker.
    • The active_nonfinance term has nothing to do with the underlying portfolio construction.
    • Example: A closet indexing fund that considers discretionary input in the stock selection process, but which essentially mirrors the weights of a passive index portfolio to avoid career risk, would be deemed active. However, to a finance person, this portfolio construction would, for all intents and purposes, be considered passive.

How Did this Confusion Start: Was it the Advent of ETFs?

First, some background: ETF sponsors must file an exemptive application to the SEC. Why? In order to operate an ETF, a fund sponsor needs to do things that are not allowed based on the Investment Company Act of 1940, so they seek relief from these regulations from the SEC.

There are two primary types of relief:

  • Index relief — granted to those fund sponsors that systematically follow a process, or index.
  • Active relief — granted to those fund sponsors that can choose to follow an index and/or invest based on their discretion.
etf relief

Source: https://www.sec.gov/rules/icreleases.shtml

A Solution: Add Active or Passive to better describe an Index

The confusion probably started because index relief is now often termed passive relief. In fact, I’d argue the term passive ETF is now more ubiquitous in the financial press than index ETF, despite the fact “index ETF” is the official wording for any ETF that operates under index exemptive relief granted by the SEC.

Of course, as mentioned earlier, by using the word passive to label index exemptive relief ETFs, we enter the twilight zone of confusion.  This is the place where rabbits seem to be mistaken for ducks and ducks for rabbits.

Some examples to highlight the point:

  • An index relief fund (called “passive” by the financial press) that systematically holds the 10 smallest stocks that start with the letter “X.”
    • Major problem. Clearly, this index ETF strategy is incredibly “active,” but labeling it “passive” creates immense confusion for investors.
  • An active relief fund that relies on a portfolio manager’s discretion to pick its 10 best stocks.
    • No issue here. This active relief fund would be called “active” by the financial press and would in all respects be actively managed.
  • An index relief fund (called “passive” by the financial press) that systematically buys the largest 500 stocks in the US stock market and owns them in accordance with their market cap weights (i.e., ~ the Vanguard S&P 500 fund).
    • No issue here. The press will label this index ETF passive because a computer runs the decision-making and this matches the financial definition of passive.
  • An active relief fund that systematically holds the 10 smallest stocks that start with the letter “X.”
    • Lot’s of confusion. The active relief fund would be deemed passive by the press because a computer is making the investment decisions, but the financial definition of this strategy is definitely active.

Here is a summary of the options and the potential for confusion:

active and index confusion

The confusion is created by the generic use of the term “index.”  Simply using the terms active index and passive index would eliminate most of the confusion when discussing various funds and strategies with the investing public.

Hopefully the financial media will help lower confusion when they discuss “index ETFs” going forward. A good example is the term smart beta, which isn’t necessarily “smart” and may not even reflect “beta.” Ben Johnson at Morningstar suggests the term strategic beta, but perhaps the term “active index” would be even more appropriate?(7)

Just a thought…

 


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References   [ + ]

1. The Cliff Asness approach of being true to the original finance definition is probably the cleanest and most transparent for the investing public. In fact, it made his famous “Top 10 peeves” at #6.
2. Here is the full version of Sharpe’s definition from the Arithmetic of Active Management.

Of course, certain definitions of the key terms are necessary. First, a market must be selected — the stocks in the S&P 500, for example, or a set of “small” stocks. Then each investor who holds securities from the market must be classified as either active or passive.

  • A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 percent of the value of the securities in the market, a passive investor’s portfolio will have 3 per \cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market2.

  • An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently — hence the term “active.”

3. academics argue over the granular detail on what determines the truly passive portfolio, or what geeks label the “market portfolio.” See the famous Roll critique as an example of this banter.
4. active share is a technique to identify the “level” of activeness
5. note: some investors might blend index/discretionary to become “quantamental”
6. Passive Discretionary? — Not really plausible since a classic passive portfolio reflects a systematic design.
7. Of course, one can additionally classify an active index fund as highly active or not-very active (i.e., closet-indexer), but that discussion is beyond the scope of this short essay (we have discussed this here and here, and are building tools to help RIAs differentiate better understand what they are buying). Active share is one technique to identify the “level” of activeness

About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • Patrick Poke

    I know that market-cap weighted indexes are generally considered to be passive, but I question whether even this can be called truly passive. For starters, someone has made an active decision that market cap weighted is the best way to weight your portfolio. Yes, you could cite evidence that supports the EMH, but then someone suggesting that equal weighted indexes are better could cite evidence that supported their point of view.

    Beyond this, decisions are made (whether algorithmic or discretionary) at the index construction level (e.g. by S&P or MSCI) as to what’s included in the indexes, based on liquidity and various other rules – AKA the index methodology.

    Personally, I advocate dropping the terms active and passive altogether and just call things what they are (e.g. a market-cap-weighted index, an equal-weighted index, or a fundamentally-weighted index). Active vs Passive just creates philosophical arguments, when really the argument should be about net returns, diversification etc. Things that actually matter.

  • I agree.

  • Spencer Ogden

    What makes market-cap weight passive is not that it is the “default” option that someone chose, but that it entails the minimum amount of trading. This is in contrast to equal weight, where re-balancing is needed to bring weights back to the target.

  • great point

  • Good follow on point. In the end, nothing is really ever “passive” — even names come in and out of market-cap weight index, you need to reinvest dividends, etc. But broad-based market-cap indices are about as close as you’re going to get to “set it and forget it”

  • sandy

    Why did you all make the switch, and is there any implication for investors in your ETF? I read the SEC difference as being one of flexibility for the fund manager. IE in #1a above the manager must stick with the system and in #2B the manager is currently following the system but is actually making a continual decision to do so vs alternatives, since he has discretion.

  • Yes, indexes are inherently active. Most of the confusion revolving around active and passive stems from lack of clarity on definitions between the parties conversing.

  • I notice market capitalizations change every minute between 9:30amET – 4:00pmET Monday through Friday. How often you trade depends on your rules for rebalancing. Some prefer every minute while some prefer a bit longer.

  • Hannibal Smith

    I’m with Patrick on this one. There is no such thing as passive investing. All porfolios must be rebalanced. All indexes have addition, deletions and reweightings. The sooner we get away from using this misleading terminology, the better.

    It’s also double silly to call “smart beta” as active but value-weight as not. Lots of return drag with value-weight and it is an active decision to use it (or not use it).