Not choosing is a choice

There is no such thing as "passive" investing

“Whatever.”

Me, when my wife asks what I want for dinner

In recent years, technology has enabled an ever-greater proliferation of specialty funds, many of them based on the findings of various academic studies. As these strategies have hit the mainstream via various funds and ETFs, a divide has widened within the wealth management industry—those who believe in active management on one side, implemented through the purchase of individual company shares, and passive advocates on the other, implemented through various mutual funds and ETFs.

I’m trying not to turn this into an active versus passive debate, because I believe that the argument is largely noise. If you really stop to think about it, you realize that there’s actually no such thing as passive investing. Because just like you eventually need to make a choice of what to have for dinner, you can’t avoid making a choice in what you’re invested in.

Sure, I can just call the restaurant and tell them to send over “whatever,” but I still need to decide which restaurant to call.

This is not a trivial matter. Deciding how your portfolio is invested is important, because it determines how your portfolio is going to behave next time the market goes down. And you’ll need to be ready to deal with it.

If I say I don’t care what I eat, it’s because in my mind I’m anticipating a decision between pizza and burgers. Honestly, I’m good with either. But if I say “whatever,” and I’m presented with a dish of grilled tofu and kale, I can’t complain. I need to eat the tofu and kale. It’s going to be hard. I’m going to regret every bite. But it’s what I signed up for.

Similarly, at a very basic level you’re going to need to decide on a strategy for your investment portfolio, and if you say “whatever” and go with whatever product is being pushed at the time you open your account, you may have to choke down some very difficult returns when the market turns against you (because it always does). Or you’ll end up bailing on the strategy and selling after a big decline, just like all of those investors in the ARK Innovation or CGM Focus Funds.

“If you choose not to decide, you still have made a choice.”

Rush, “Free Will”

Pay no attention to the man behind the curtain

Apart from all of the factors that cause us to question the veracity of the Efficient Market Hypothesis, the process of indexing itself has several problems. Yes, it’s a great solution for small investors whose only other choice is often costly funds sold through their bank branch, but it leaves much to be desired for larger investors.

There’s a romantic notion around passive investing that you’re buying the entire market with one purchase. With the single click of a mouse, you now own a diversified basket of the world’s largest and most successful companies.

The reality is a bit more complicated. Have you ever considered who decides which stocks end up in the index? Well, in the case of the S&P 500, it’s a committee that meets once a quarter. Want to know who’s on the committee? You can’t. Apart from the chair, it’s a secret. And yes, I’m totally serious about that.

There are some rules around which companies get in and which don’t, but there is a lot of subjectivity involved as well, and so the committee votes on who’s in and who’s out—majority rules. In the case of a tie, they continue to hash it out until one anonymous member sways to the other side.

Getting included in the S&P 500 is kind of a big deal. According to S&P Global, there was about $15.6 trillion benchmarked to the index at the end of 2021. So the act of substituting one company with another one has the potential impact of transferring billions of dollars of share ownership in a short period of time. The power afforded to an anonymous indexing committee is, quite frankly, astonishing.

You might suppose this isn’t such a big deal as long as there is very little turnover in the index. It would be fair to assume that decisions of this sort would be very rare.

You would be wrong about that. Since the S&P 500 as we currently know it was created in 1957, only sixty of the original 500 constituents remain. Notably, turnover in the index is increasing, with the average tenure declining from thirty-three years in 1964 to an estimated twelve years in 2027.

So it’s critically important for the passive investor to know that the decision they have made is for their portfolio to be determined by a largely anonymous committee that votes on a majority rules basis. Other than the fact that the S&P 500 (and the vast majority of other indices) own an unwieldy number of stocks, this isn’t quite as “passive” as you might have imagined.

I’ve focused on the S&P 500, but other indices work in much the same manner. And whether there’s a committee behind it or a set of automated rules, inclusion in the index originates with a person, or group of people, who decide which stocks are in, and which stocks are out—through either judgment or a set of preprogrammed automated rules.

That’s the first thing you need to know about investing in an index. When you get down to it, it’s based on many of the same principles as the active management that its proponents spend so much time denigrating. At some point, someone, somewhere, is making a choice to include one company, while excluding another. And in the case of the S&P 500, you don’t even know who these people are!

Now here’s the one argument I agree with: that, via indexing, you have the ability to keep your costs as low as possible. You’re buying an arbitrary basket of stocks, and therefore don’t have to worry about the costs of detailed research. As the theory goes, this makes up for the variability in results you might see with an active manager. And because the total market return is the average of the returns experienced by all market participants—and they are bearing the cost of research, which passive investors aren’t—this is incontrovertibly true.

But how then to decide which indices to buy in order to execute your passive strategy? A major complicating factor is the huge proliferation of indices that have arisen from the ETF mania. So much so that, in May of 2017, Bloomberg magazine famously announced that “there are now more indices than stocks.” Those who choose to pursue a “passive” strategy are therefore faced with the very difficult decision of which indices to buy. As you can see, the so-called “democratization” of investing has quickly devolved into a very complex area where most people will need some sort of professional guidance. That costs money, and that may completely eradicate the cost advantage of an indexing strategy.

I haven’t even yet mentioned one of the biggest problems with blindly buying index funds… I’ll get to that next week.