March, 2022
An evolving investing landscape has rendered simple “active” vs. “passive” labels outdated as useful descriptions of contrasting investment management approaches. A more nuanced framework for thinking about approaches once considered opposing is to distinguish that strategy’s philosophy from its methods of implementation. For example, Dimensional’s systematic structured strategy combines a financial science-based passive philosophy with active flexible implementation.
As one of the last generation to grow up with a rotary dial and later touch tone phones in our home, I remember there once was a clear distinction between phones and early personal computers. Phones were utilitarian devices, while computers became gateways to knowledge through floppy disks and then later what was called “the internet” accessed through phone lines. Nowadays, that distinction has dissolved. For users in many situations, iPhones obviate the need for a personal computer as well a phone line.
Similarly, the tremendous revolution over that time in financial science and financial services has blurred old distinctions between active and passive investing. “Active” investing depends on researching companies and assessing their “value” in order to identify securities supposedly, generating high direct and indirect management costs in the process. “Passive” investing avoids research costs by embracing market prices as estimates of fair value, and substantially reducing many trading-related costs.
The current landscape which developed new investing vehicles suggests that the once popular binary labels used to distinguish opposing investing philosophies with opposing approaches for trading are no longer adequate. A more nuanced framework better captures the new spirit of the old “active” and “passive” definitions — and more accurately takes into account essential new distinctions in how active and passive strategies increasingly are being implemented by investors as the cost of trading shares drops and the speed of trading access increases.
Diminished Distinctions
Index investing developed from a large body of academic evidence showing that traditional active methods of selecting stocks and timing markets added doubtful value. Studies documenting underperformance by active fund managers relative to holding simply a portfolio replicating the general market supported the sentiment that market prices were largely fair. Attempting to discover under- or overpriced securities — and missing securities that may have done better in the process — was akin to flipping a coin. So, the arrival of the first index funds from Vanguard represented the beginning of a shift over the following decades towards embracing market prices by investors and becoming part of popular and regulatory conventional wisdom.
Because early indexing was not involved in researchers’ traditional bottom-up company analysis or top-down economic trend forecasting, it became pejoratively labeled as “passive” investing. However, this stretches the definition of “passive.” A sailboat without its own propulsion must be actively manipulated to keep wind in its sail. Indexes are not perpetual motion machines free of maintenance, but require periodic management through additions, deletions, and security reweighting. Index construction rules are often designed to accommodate the mutual funds and exchange-traded funds. (ETFs track the indexes but trade like stocks during the day rather than like mutual funds at the end of the day.) Index turnover is further reduced, for example, by limiting the number of rebalancing events and imposing thresholds on security weight changes.
Also blurring the line between active and passive investing approaches is that many professional investors are aggressively using index funds to pursue an active investment approach based on forecasts of market or sector signals. For example, according to Bloomberg, the largest S&P 500 ETF had the highest average daily trade volume of US-listed securities in 2021, at $31 billion USD. It is reasonable to assume a portion of that trading activity represented changes motivated by speculative investor viewpoints due to the ease and low cost of exchange trading, rather than buy-and-hold longer-term allocations for wealth planning strategies.
An evolving process for categorizing investments separately applies the active/passive label for an investment strategy’s underlying philosophy and then to its underlying methodology for implementation. While some investment approaches still appear purely active or passive under this framework, many investment management approaches have a foot in both camps.
Exhibit 1: Active vs. Passive Management Labels Get More Complicated
Stock-picking and market-timing strategies are universally described as “active,” as the 2×2 framework in Exhibit 1 labels it. Active approaches are strongly rooted in the conventional philosophy that deeply believes that mispriced securities or market segments can be identified and resulting opportunities profitably exploited. (And certainly for managers, they are, regardless of the outcomes.) The execution of this philosophy creates a structure substantially deviating from market capitalization weights as it concentrates on perceived investor mispricing opportunities.
Market index funds, on the other hand, fit a classic “passive” definition along both vectors. The raison d’être of index funds is a complete acceptance of the market’s pricing power, a concession that trying to consistently outguess markets is unlikely to succeed after costs. The structure of most market index funds is true to that belief, generally holding the entirety of the prescribed asset class or market segment with no deviations motivated by expected-return targeting.
Due to intense industry competition, the ETF landscape has spawned an expanding segment of index ETFs that do not track broad market indices, instead offering more targeted exposure for investors who are looking to time markets or concentrate on particular sectors. For example, you can find a social sentiment ETF that holds the top 75 large cap stocks based on investor exuberance measured through channels such as social media and news outlets. Another example is a millennial-themed consumer ETF that seeks to ride the coattails of companies benefiting from millennials’ consumption preferences. Then there are funds focused on cybercurrencies like bitcoin.
These are examples of index funds that sit apart from traditional passive approaches. They track indices, so are passive in structure. But the philosophical underpinning of these niche ETFs is inconsistent with accepting market prices as fair. An investor who believes stock prices reflect all available information about companies likely would not allocate in a trendy stock ETF with only speculative potential. Our framework assigns an active/passive designation to these index ETFs.
The final quadrant expresses Dimensional Fund Advisors philosophy. It starts with a firm belief in the power of markets to competitively set fair prices for both buyers and sellers. In that sense, Dimensional is aligned with the index industry’s original passive approach. Dimensional then finds information embedded in market prices through techniques derived from financial science, and then attempts to increase expected returns daily by their flexible trading process, adding value beyond the index funds. The implementation is therefore active — the firm is not beholden to rigid index construction rules. So, Dimensional lands on passive/active quadrant: an approach seeking to outperform markets without actively attempting to outguess them by forecasting or making bets.
Conclusion
Dimensional’s growth over four decades, progressing from an obscure one fund company derided by competitors to presently positioned within the “top ten” of mutual fund and ETF companies in highly competitive industry, suggests that many disciplined investors have found that allocating a significant portion of their serious money into Dimensional passive-active strategies has provided them a successful financial experience for helping them achieve their goals, hopes and dreams.
ADDENDUM:
Remarks to Investors on the current Ukrainian Crisis
David Booth, founder and former CEO of Dimensional Fund Advisors
In times of instability, it is essential to assess whether markets are functioning properly. Right now, markets are functioning properly (despite today’s unusually high level of price volatility). Therefore, markets are behaving as we expect them to — they are open, trades are executing, buyers and sells are coming together and setting prices.
The world has seen many crises during my more than 50 years of studying markets, which has taught me that uncertainty and volatility are a part of investing. Time and again, markets have rewarded investors willing to focus on their goals and stick to their long-term plan.