How to Approach Active Investing With a Passive Mindset?

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What do John C. Bogle (founder of Vanguard) and Warren Buffett (billionaire investor) have in common?
Both are successful investors.
Both have a cult-like following.
And both of them support passive index-investing.
What most people don’t realize is that there’s another hidden commonality.
While both are proponents of a passive investment strategy, both actually practice active investing!
According to research, Warren Buffett’s firm, Berkshire Hathaway, holds less than 20% of the stocks they buy for more than 3 years. 60% of the company’s stock holdings are churned in less than a year.

That’s anything but passive or index investing.
Jack Bogle, when interviewed by Bloomberg, had this to say “When you look at global market capitalization it’s true that the U.S. accounts for about 48 percent and other countries 52 percent. But the top three markets outside the U.S. are the U.K., Japan, and France. What’s the excitement about there? Emerging markets have great potential, but have fragile sovereigns and fragile institutions.
I wouldn’t invest outside the U.S. If someone wants to invest 20 percent or less of their portfolio outside the U.S., that’s fine. I wouldn’t do it, but if you want to, that’s fine.
That’s active asset allocation strategy at play.
Clifford S. Asness, managing and founding principal at AQR Capital Management, notes – “To me, if you deviate markedly from capitalization weights, you are, by definition, an active manager making bets. Many fight this label. They call their deviations from market capitalization – among other labels – smart beta, scientific investing, fundamental indexing, or risk parity.
Some might say Buffett and Bogle don’t walk the talk. But I feel that the very definition of passive vs active is weak.

There’s no such thing as passive investing

Rick Ferri, investment analyst, and author of “The Power of Passive Investing”, admits that there is no such thing as passive investing.
Rick says, “It’s true. Passive investing in its purest form doesn’t exist. Only lesser degrees of active management exist.

Passive Investing – Decisions an investor needs to make

Let’s assume that you are a passive investor. Here are the number of decisions you have to make.

  1. How much money should I invest?
  2. When should I invest?
  3. What should be my ideal asset allocation?
  4. Which index should I pick out of the 1500+ indices just for equities?
  5. Which product should I choose?
  6. How many products should I invest in?
  7. How often should I review my portfolio?
  8. How do I conduct my portfolio review?
  9. I need money. From where do I withdraw?
  10. How do I rebalance my allocation based on withdrawals or market movements?
  11. How should my asset allocation change now that my goals have changed?
  12. How can I make my investments more tax-efficient?

Each question has additional complexities. You need to make tens or hundreds of decisions every year, even with a passive investment approach.

Passive Investing – Decisions an investment manager needs to make

Surely anyone can run an index fund, right? After all, all you have to do is follow the index. How hard can that be?
Tell that to Vanguard 500 Index Fund manager, Gus Sauter. Once he listened to a prospective investor say over the phone that ‘a monkey could run that fund.’
But it turns out, there’s a lot more to managing an index fund. As per Gus Sauter, managing an index fund is a “full-contact sport.”
Here are some of the decisions an index fund manager has to take on an ongoing basis:

  1. When should I trade?
  2. What should I trade?
  3. How do I manage the constant incoming and outgoing cash flow?
  4. How do I minimize the tracking error?
  5. If the index is too large, how do I select the optimal “sample”?
  6. When should I use leverage, sampling, or derivatives?

An investment manager must juggle all of this, keeping in mind that overall costs should be low.

Behavioral risks in investing

Often, the biggest threat to an investor is the investor himself. Behavioral biases play a huge role in dragging down returns.
This is why investor returns are often lower than investment returns.

If you are actively picking stocks, constantly monitoring your portfolio, and making frequent changes to your portfolio based on market movements, there’s a good chance that you’ll get lower returns than a passive investor who invests in an index fund.
Sometimes, less is more.

Breaking down passive/index investing

Most people recommend a passive way to invest because it’s simple and it works to a fair degree.
Let’s break down the reasons why passive/index investing is popular.
#1: Lower fees
Why? High fees eat into your returns. You should minimize your fees.
How? Often, costs are proportional to the number of trades. Lower the number of trades, and you’ll usually lower the fees.
#2: Be the market. Don’t try to beat the market
Why? The hypothesis is that markets are efficient. It’s very unlikely that you’ll be able to beat the markets.
How? Stay close to the broader market index by investing in an index fund.
#3: Invest. Don’t speculate
Why? You can’t possibly time the market. Invest irrespective of market conditions.
How? Automate your investments using an auto deposit and take advantage of dollar cost averaging.

The bigger problems no one’s talking about

Asset allocation and risk management.
We believe that asset allocation is far more important than picking the right products.
After the Great Recession of 2007-08, markets crashed by more than 50%. Your portfolio could have dropped 50% or even lower.
Most people cannot stay calm when their portfolio is down by 50%.
Even with an 8% annual return, it could take up to 9 years for your equity portfolio to return to its original value.

Often, people pull out at the bottom and then stay away from the market. They re-enter when the markets start to peak again.
That’s the exact opposite of the popular investment mantra – “Buy low and sell high.”

How to invest better with an active-passive approach?

#1: Identify your desired asset allocation
“Since 2004, working on asset allocation could have potentially yielded about ten times more alpha than security selection.” – qplum research.
Asset allocation plays a crucial role in investment returns. If you are not sure what your asset allocation should be, consult a financial advisor.
#2: Consider costs in the context of the service
Your goal should be to keep costs low. However, free does not always mean good and good does not always mean expensive.
If you use an investment service, choose one with an all-in-one inclusive fee, so that you are not paying excessive trading charges.
Firms often separate investment fees and trading fees to make the product look more attractive.
Hedge funds can charge you a 2% fixed fee and a 20% performance fee.
Target date funds have an average 0.66% expense ratio according to morningstar research report.
Investment advisors typically charge around 0.5 to 1% of your total assets under management (AUM). In addition, there could be ETF/Mutual Fund expense ratios, transaction, brokerage, and other costs which could lead to another 0.5 to 1.5%.
Calculate your returns net of fees when making an investment decision.
#3: Constantly monitor your asset allocation and make changes as required
In this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin
Make asset allocation decisions based on:

  • Changes in portfolio value due to value changes in the underlying asset class (fixed income, equities, and real estate)
  • Changes in market conditions causing some asset classes to become extremely high/low risk

#4: Apply risk management
Risk management is not about timing the market. It’s about minimizing losses and having a plan to re-enter systematically. The quicker you can contain losses, the faster you can break even.

Systematic risk management can help move your investments to cash, if required, during extremely volatile times and provide a path to re-enter the markets when conditions are favorable.
It is often a more practical and cheaper alternative vs buying options or other forms of insurance.
I know that it’s easier said than done. Keeping your emotions at bay is no easy task. But as an investor, you should learn to put logic above emotions.

How can qplum help with active-passive investing?

When Gaurav and I started qplum, our goal was to make investing a scientific process that is accessible to everyone.
Our inspiration comes from Benjamin Graham. In 1952, he wrote a paper “Towards a Science of Security Analysis”. He wrote about a “trustworthy tool”.
The last line of the paper is – “security analysis may begin–modesty, but hopefully–to refer to itself as a scientific discipline.”
We believe that deep learning can be that tool to make investing a science. We use deep learning to summarize the market conditions. All investment and asset allocation decisions are taken by our algorithms along with continuous oversight by our quant team. This helps eliminate emotion-driven decisions and human biases.
If you want to use data-driven decision for your asset allocation while investing for the long-term, qplum can be a good fit. Set up a call with our team to know more or talk to our A.I. powered bot to start a financial assessment.
Mansi Singhal is the CEO of qplum, an online financial advisory firm. Before starting qplum, she worked on Wall Street for different banks and hedge funds. She received her Master’s in Computer Science from the University of Pennsylvania and holds Series 3 and Series 65 certifications. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments or investment strategies.

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