Active vs. Passive Investing: Part 1 |

The article, "Why I Prefer Index Instruments" stirred up a little discussion on Seeking Alpha.? Within all the comments was a link to a most interesting 12 page rebuttal of passive investing.? I suggest readers print out this article and number the bullet points of each section.? My plan is to write twelve (12) blogs using as an outline the twelve points discussed in the Active vs. Passive Investing Returns article.

Point One:? Consider that the return claimed by the indexers is an index's theoretical total return (as made actionable with an ETF).? But investors' realized returns are very different.

The above point is amplified by eight bullet points in the twelve page article.

• The first point concerns cash flowing in and out of a portfolio throughout the year.? This point is no different for a passive or active investor.? The TLH Spreadsheet accurately handles cash flowing in and out of the portfolio.? The passive investor is less likely to be moving in or out of the market at the wrong time.? Bullet one carries no weight against passive investing.
• Bullet point two assumes investor behavior works against passive investing.? Not so.? The passive investor stays invested and is less likely to be influenced by unusual market behavior.? The assumption stated in bullet two is bogus unless the "passive investor" turns active.
• Bullet three is also incorrect, particularly when it comes to index investor.? Check this link for clear definitions on investing styles as defined by Harold Evensky.? Keep in mind that the ITA Risk Reduction model is neither passive or index investing.? It is a form of active management using index ETFs.
• Bullet 4 states that indexers rebalance between asset classes during the year.? True, and if we use Evensky's definition of passive investing, rebalancing during the year falls well within his definition of passive investing.? Here at ITA Wealth Management, we use Threshold Percentages to know when to rebalance the portfolio.
• Bullet 5 states that passive investors dollar-cost-average their way into positions, further changing their returns from the index and increasing their costs.? Part of this is true and part is false.? Yes, the passive investor saving money each month will be dollar-cost-averaging, but if the benchmark is measured accurately, cash flowing into the portfolio is measured correctly.? Most portfolio management tools correctly measure the portfolio performance, but they fail to come up with the correct return for the benchmark.? True, one cannot compare portfolio returns with an index such as the S&P 500 unless it is set up properly as we do in the TLH Spreadsheet.? Using commission free ETFs, as we do with TDAmeritrade, it costs a lot less to operate a portfolio made up of the ETFs we use compared to an all stock portfolio.? Bullet 5 is another bogus argument against passive investing as it assumes the Internal Rate of Return (IRR) of the portfolio is not calculated properly, nor is the IRR of the benchmark properly measured.? While this may be true for most investors, it is not true for Platinum members who are using the TLH Spreadsheet.
• It is true, many passive or semi-passive investors do not reinvest dividends quickly.? In a rising market, this works against the performance of the portfolio.? In a declining market, it aids the IRR of the portfolio with respect to its appropriate benchmark.? The same problem applies to the active investor. Bullet point 6 is no deal breaker against passive investing.
• Bullet 7 indicates that owned funds may have tracking errors against their benchmark.? This is true, but we tend to use highly liquid ETFs and as a result the tracking errors are minimized.? This does not imply they are eliminated.? Stock picking has its own bid-ask issues.? Once more, this is no argument against passive investing.
• The last point in Part 1 is the cost for advice.? I suppose Platinum members should subtract $60 from their portfolio as the cost to operate.? Using commission free ETFs, as we manage to do most of the time, reduces portfolio costs to be mere pennies.? Stocks are not commission free and this works against active management.?

Summary of Part 1:? Not one of the eight arguments indicate in any way that active management is superior to passive management.? In general, any problems associated with passive management, as defined by Evensky, are overcome with accurate portfolio and appropriate benchmark tracking.? It is important to emphasize 'appropriate' benchmarks as it is common to compare the performance of a portfolio with an inappropriate benchmark.

Let me underscore the point once more that probability arguments conclude there will be active money managers who will outperform their benchmark over long periods.? Is it luck or skill and can it be done over a 40- 50-year investing career?

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Source: http://itawealthmanagement.com/2012/02/02/active-vs-passive-investing-part-1/

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