The active versus passive investing debate continues to receive attention with strong opinions on both sides. We find the discussion too narrowly focused on the use of active versus passive funds within a portfolio. Fund selection is a secondary decision that won’t have the intended impact if asset allocation decisions aren’t accurate. Investors often confuse passive fund endorsements as synonyms with adopting a passive portfolio management approach. These are very different concepts. While the active versus passive fund decision is important, it’s not the main driver of returns.
Studies show that upwards of 90 percent of portfolio returns are determined by asset allocation. Investors should spend more time on decisions that are most impactful. Focusing on fund selection rather than asset allocation is like arguing about the best oil drilling technique to use in an area that has no oil.
Consider the two most recent stock market crashes, the tech bubble and the financial crisis, when the S&P 500 experienced declines of 46 percent and 53 percent respectively. Were passive investors excited about the low costs of their stock funds during this period? Were investors utilizing active funds thrilled their fund outperformed its benchmark and declined 50 percent instead of 53 percent? Shifting to a more conservative allocation during these periods of severe market stress was the only way to mitigate these enormous declines. The utilization of active or passive funds was of little consequence if the portfolio allocation was too aggressive.
How about investors that bailed out at the depths of the financial crisis, swore off equity investing forever and missed the 300 percent+ rebound? Are they boasting that their passive bond fund has a low expense ratio? Focusing on active versus passive funds wouldn’t have been impactful if investors didn’t realize that at some point it was time to start increasing their equity exposure. These examples, while extreme, highlight that asset allocation decisions should be investors’ primary concern.
Asset allocation is more than determining how much risk to carry, but also where to allocate risk and to what degree. Investors who maintained large allocations to international stocks over the past 10 years would agree. During that time, international stocks lagged domestic stocks by a whopping 90 percentage points. A $100,000 investment in the S&P 500 10 years ago would today be worth almost $90,000 more than if those funds were invested in international stocks. That isn’t a gap that can be overcome by the low costs of passive funds or by good stock picking from active managers. This is representative of the benefits or consequences of asset allocation decisions.
Some would argue that it’s difficult to get these asset allocation decisions correct and therefore it makes sense to maintain a passive asset allocation. We firmly disagree. True passive asset allocation isn’t really possible. A truly passive allocation approach would mean holding every investable asset in proportion to its global value. This would include stocks and bonds, but also assets such as apartment buildings, raw land, commercial real estate, commodities, livestock, fine wine, art, private companies, etc. Maybe achievable for multi-billion-dollar institutional investors, but not remotely practical for individual investors. Since we can’t be truly passive, investors must make active asset allocation decisions.
What about the often referenced 60/40 approach, or more specifically 60 percent allocated to the S&P 500 stock index and 40 percent allocated to a diversified bond index? Isn’t that a passive approach? While simple, it’s certainly not passive. The S&P represents the 500 largest U.S. companies while the United States only represents about 25 percent of global GDP. The decision to utilize the S&P for the entirety of an investors’ equity exposure means making the active decision to forgo opportunities in smaller company stocks and to ignore investment options in the other 75 percent of the world. While striving to be passive, the result is a lack of proper portfolio diversification and significant active bets.
Attempting to utilize a passive allocation approach within the fixed income segment of portfolios is also challenging. An investor’s tax rate should be an important input for their fixed income strategy. It’s often advantageous for investors in high tax brackets to favor tax-exempt bonds while taxable bonds may be a better option for investors in lower tax brackets and for tax-deferred retirement accounts. But there are no hard and fast rules here and each investors’ unique circumstances should be considered. This is starting to sound like another active management decision.
Even if investors could easily manage their bonds in a passive manner, would they really want to? According to Vanguard, foreign bonds comprise roughly 60 percent of the $80 trillion worldwide fixed income market. Is it prudent for U.S. investors to allocate 60 percent of their fixed income exposure to foreign bonds? Outside of the prudency question, is it an attractive investment decision with a large portion of international bonds offering investors negative yields? Yes, investors actually pay borrowers to hold their money.
What other types of wonderful opportunities would investors be exposed to within international bond markets? How about the recently issued 100-year maturity Argentinian bond? As Howard Marks from Oaktree Capital Management L.P. points out, Argentina has defaulted on its obligations eight times in its 200-year history, with no fewer than five defaults in the past century alone. How about European “junk bonds” which as of the time of this writing offer investors a similar level of compensation or yield as ultra-safe U.S. Treasuries? These are good examples of poor investment opportunities and ones that informed investors should avoid. But attempting to sidestep investments that offer bad risk-to-reward propositions fits firmly in the category of active management.