Index vs. Passive Investing

Harold R. Evensky, in his Wealth Management: The Financial Advisor’s Guide to Investing and Managing Client Assets book, makes a distinction between index and passive investing.  Few readers are unaware of the differences between active and passive management, but the subtle definitions between index and passive management deserves some attention.

I subscribe to the principles of index investing even though I break the rules from time to time by adding an individual stock to a portfolio.  Any time a manager delves into stock picking, market timing, and excessive rebalancing, they move from passive to active investing.  To tell the truth, it is rare to find a truly passive money manager.  The one portfolio tracked here at ITA Wealth Management that falls into the passive management category is the Schrodinger Portfolio.  About the only trades made in the Schrodinger are related to rebalancing and reinvesting of dividends.  Those are not considered acts of active management.

All the ITA portfolios subscribe to the philosophy of index investing.  In other words, the portfolios are built around non-managed index ETFs.  In the future I may add a fundamental index ETF or two to a portfolio.  If I follow up on this idea I will tilt slightly towards active management.  To learn more about what fundamental ETFs are all about, read Robert D. Arnott’s book, The Fundamental Index.  If one uses fundamental index ETFs, the active management is left up to someone else so the active part is one step removed from the person tracking the portfolio.

This morning I was reading through the category of Passive vs. Active and realized there is a continuum in play between these two major investment philosophies.  The active investor is one who thinks they can apply skills of analysis to stock selection.  That analysis is superior to other smart people on the other side of the trade.  At least that is the idea.  Investors who think they have these skills need to carefully monitor their decisions with respect to an appropriate benchmark.  Let’s leave it at that.

The financial literature is replete with arguments favoring index investing over selecting individual stocks.  Neither does the literature support market timing or using models such as the ITA Risk Reduction or momentum investing.  We are testing these models and are test results will show whether we gain or lose ground with respect to the ITA Index and/or VTSMX benchmark.  There are limited studies that show some of these models work – at least over certain time frames.  Here at ITA I was using the ITARR model with the Kenilworth, Maxwell, Madison, Gauss, and Euclid portfolios, but more recently shifted to a modified version of the “Dynamic” plus SHY as explained in The Feynman Study.  Eventually I plan to move that material to this new website.  That leaves the Einstein, Bohr, Kepler, Curie, and Newton as portfolios to be passively managed with some judgments applied from time to time.  For example, the recent decision to simplify the Newton was an act of active management.  Within the Newton I am reducing the number of individual stock holdings and moving more toward a portfolio populated with index ETFs.  In the latest update I also applied some of the guidelines from the “Momentum” plus SHY model.  To keep abreast of what is going on, follow the explanations when a portfolio comes up for review every 33 days.

The recent addition of the “Rankings” tool has the possibility to aid IRA readers in lifting the Efficient Frontier (EF).  Is it possible to find a group of index ETFs, be they non-managed or fundamental, that creates an EF curve that overall moves toward the northwest of the Return vs. Volatility graph?  We are always trying to create portfolios that have the possibility of generating greater return with equal or lower volatility.  In a sense, this is active management, but not as aggressive as stock selection.  We are trying to improve our passive positions, an ongoing effort of any portfolio manager.