W. Scott Simon
This month’s article is the first in a series that examines active investing and passive
investing within the context of modern prudent fiduciary investing.
Before going any further, I must disclose my own bias: I am committed to passive
investing. I wrote a book in 1998 called Index Mutual Funds: Profiting from an Investment
Revolution (now out of print) for which John C. Bogle provided the introduction. That book
included some material on the Uniform Prudent Investor Act and the Restatement 3rd of
Trusts (Prudent Investor Rule) that led me to write an article in a California legal periodical
on index funds and the California Uniform Prudent Investor Act. That article, in turn, led me
in 2002 to write The Prudent Investor Act: A Guide to Understanding.
While I did bring a predisposition to favor passive investing as I went about analyzing the
process described in the Act and the Restatement in my latest book, I tried, nonetheless, to
be as balanced as possible in presenting that analysis. I would, therefore, ask all those who
are ready to fire off critical e-mail to me as a result of reading this series of articles to
please remember that.
I would also ask those who are committed to active investing to remember that there is a
big difference between investing your own money and investing money for others as a
fiduciary. You can invest your money to your heart’s content in the latest, hottest
investments, but the standards are a lot different when you invest money that’s not yours.
This doesn’t mean that fiduciaries are restricted only to U.S. government bonds; it just
means that there are certain rules of prudence by which fiduciaries must conduct
themselves.
Two Fundamentally Different Approaches to Investing
A fiduciary implements the asset allocation for a trust portfolio with an appropriate
investment strategy. Before selection of any investment strategy, it would behoove the
fiduciary to understand the significant differences between two fundamentally different
approaches to investing–active investing and passive investing.
The decisions made by a fiduciary in selecting either an active or passive investment
strategy (or some combination of both) to implement a trust portfolio’s asset allocation
stand at the very center of the issues surrounding fiduciary responsibility.
Active Investing
Many investors (whether acting on their own or in a fiduciary capacity for others) engage in
an active approach to investing. That is, they invest in each time period in the investments
they believe offer the best odds of maximizing portfolio values. In short, they attempt to
“beat the market.” These attempts involve stock picking and market timing.
The goal of stock picking (whether individual stocks or stock mutual funds) is to identify,
and thus profit from, mismatches between the current market prices of stocks and what are
perceived as their “true” underlying values. Restatement Commentary defines active
investing as involving searches “for advantageous segments of the market, or for individual
bargains in the form of underpriced securities.”
The goal of market timing is to shift money in and out of different investments to profit from
short-term cyclical events in financial markets. Most of the money managed by
stockbrokerage firms, trust companies, individual investment advisors, and others is
invested using active investment strategies.
The investment information system, composed of the media, mutual fund families,
stockbrokerage firms, investment advisory services, and other entities, derives vast sums of
money by encouraging investors to believe that they can beat the market. Hopes of finding
the next hot stock tip, identifying the next winning mutual fund, or crowning the next
investment guru saturate this world that many investors live in and from which they get
their information about investing. This system is enormously powerful in how it affects the
emotions of investors (both amateur and professional) and how it impacts their investment
decision-making.
Although both the Act and the Restatement permit active investing, Restatement
Commentary cautions fiduciaries about the perils that can characterize this approach to
investing. These perils include the greater risks and higher costs and taxes of stock picking
and market timing:
Active strategies, however, entail investigation and analysis expenses and tend to
increase general transaction costs, including capital gains taxation. Additional risks
also may result from the difficult judgments that may be involved and from the
possible acceptance of a relatively high degree of diversifiable [i.e., uncompensated]
risk. These considerations are relevant to the trustee initially in deciding whether, to
what extent, and in what manner to undertake an active investment strategy and
then in the process of implementing any such decisions.
Passive Investing
Other investors engage in a passive approach to investing. Passive investing includes
investing in index mutual funds and asset class funds. The goal of passive investors is to
match a market return. Since this goal is more modest than that of active investors who
attempt to beat the market return, many investors seem to think that passive investing is
somehow safer than active investing.
Even though both the Act and the Restatement permit passive investing, fiduciaries should
understand that passive investing is no panacea for escaping investment risk. Because “risk
is risk,” there’s no guaranteed safe way to reap the rewards of investing in financial
markets. Although no amount of diversification can reduce the compensated risk that’s
inherent in all investment portfolios (whether active or passive), passive investing is
demonstrably the best way to rid a portfolio of as much uncompensated risk as possible
(and the only way of eliminating the risk of underperforming a given financial market).
Nonetheless, fiduciaries should understand that passive investing cannot eliminate the risk
of losing money.
Index Mutual Funds and Asset Class Funds
The manager of an index mutual fund seeks to capture the long-term performance of the
target index tracked by the fund. This is achieved by holding in the fund all (or a sample) of
the investments that are represented in the index in the same proportional amounts. An
index is representative of an asset class, which is made up of investments with common
characteristics. Usually index funds track the performances of widely recognized indexes.
The manager of an asset class fund seeks to capture the long-term performance of the
underlying asset class tracked by the fund. This is achieved by holding all (or a sample) of
the investments that compose the asset class in the same proportional amounts. This type
of fund captures returns by purchasing securities with comparable risk/return characteristics
according to an identifiable factor such as market size. An asset class fund may or may not
track an index.
Comparing an Index Fund to an Asset Class Fund
Rex Sinquefield, a pioneer in passive investing and who along with Roger Ibbotson in the
1970s was the first to present in an organized and comprehensive way the historical returns
of discrete asset classes, contrasts the trading practices of managers of index funds with
those of managers of asset class funds:
[Index fund managers] tend to hold securities in their portfolios in the exact
proportions of the target universe…. [They] do not materially overweight a security
held in the target index. Maintaining target-like portfolio balance seems to be their
primary concern…. Index fund managers] tend to seek ‘immediacy of execution.’ In
general, when orders are placed, brokers are instructed to complete all or most of
the buy program in a few days, at most…. [In contrast, asset class fund managers]
may overweight positions by purchasing large blocks [of securities] below current bid
prices and underweight positions by trying to avoid purchases at or above current
ask prices…. A large fraction of [the] portfolio holdings depart from perfect
balance…. Brokers are instructed to try to purchase securities without pushing
prices. As a result, a large portion of [the] buy program will be unexecuted, even
after several weeks, and many positions will be underweighted. Uninitiated blocks [of
securities] are considered if the execution terms are favorable, so many positions will
be overweighted.
Absent trading rules and other investment techniques, index funds and asset class funds are
similar in the sense that the managers of neither type of fund 1) pick stocks for the purpose
of trying to beat the market, 2) market time, or 3) attempt to predict the future.
In next month’s article, I’ll discuss how the simple arithmetic of a zero-sum game creates a
powerful argument in favor of passive investing.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.