3 Tips To Avoid The Active Vs Passive Trap

As financial products evolve into increasingly automated and systematic strategies I have begun to notice a big problem – fund managers are increasingly referring to their strategies as “passive”. It’s clear why this is happening – a systematic strategy could arguably be referred to as a passive strategy and passive is synonymous with good. So it’s in the interest of fund companies to avoid being labeled as “active” because then they can call themselves passive and still charge higher fees. But as I’ve noted many times over the years this is a dangerous discussion that can mislead investors if you don’t have a sound understanding of the underlying dynamics.

For example, here’s WealthFront calling their Risk Parity mutual fund “passive”. Risk Parity is a relatively simple strategy. You pick certain asset classes and you weight them by trying to create equal risk exposures between them. For instance, bonds are generally less risky than stocks so a 50/50 stock/bond portfolio isn’t equally weighted in terms of where its risk comes from. So you could leverage your bonds by a certain amount to create greater parity between the two assets. There are a billion different ways to implement such a strategy, but they are all an active deviation from the Global Financial Asset Portfolio. And they will almost certainly result in higher taxes and fees than just buying and holding the GFAP.

Now, this problem is getting worse as time goes by. WealthFront isn’t the first offender and they’re far from the worst. After all, I started noticing this in hedge fund replicating ETF prospectuses after the Financial Crisis and it made my head explode. This view, that we are all active, wasn’t well received at first, but over time more and more people have come around to my view.¹ The problem was, when I started raising a big stink about this issue there was no consistent definition of active vs passive. You might think that passive means low fee and inactive but that can’t be right because then Warren Buffett is passive and he’s obviously trying to beat the market by picking stocks. Or you might consider any rules-based or systematic approach that avoids discretion to be passive, but that can’t be right because then a day trading algorithmic 2&20 hedge fund could be considered passive.