There is no “Passive” Approach to Asset Allocation
By Henrik Lumholdt
The fathers of the efficient markets hypothesis have reasons to rejoice. Recent years have seen vast amounts of investment money flowing away from what has traditionally been called actively managed funds towards passive index funds, ETFs and the like. And the motivation for this is just what the academics had always said: too many of the actively managed funds underperform their benchmark, especially when fees are taken into account.
A slight irony in all this, is that the theory wouldn’t really work if everyone subscribed to it, which was pointed out already back in 1980.[i] The implication of informationally efficient markets is that market participants should avoid spending resources on researching individual stocks and bonds since their prices already reflects all relevant information. But if no one bothers to collect and analyze information, how can markets be supposed to reflect it correctly? Put in economics terms, this cannot be a market equilibrium.
So, maybe there will soon be an occasion for critics of the idea to rejoice. The now fewer active managers should have a much better chance of outperforming their benchmarks, given the much greater proportion of passive market participants.
Active versus Passive: what does it mean anyway?
The practical side of all this is that the distinction between active and passive investment management is getting blurred. A great part of the reason for this is that the asset management industry is now offering a panoply of investment products under the heading of “factor investing” which don’t seem to fit the standard definitions very well. These products apply factor tilts, such as being overweight value stocks or small caps, or using momentum strategies. Compared to standard cap-weighted indices these products would therefore be classified as active. However, they are typically based on algorithms which mechanically select the relevant securities rather on the discretionary decisions, which makes them look more passive. Tricky one!
Another, and arguably more important, question is to what extent investors can avoid making decisions. If you are slightly pedantic, you might point out that even investing in a stock index such as the S&P 500 involves a view. After all, even such a broad index does not represent all the stocks in the market, and since all stocks must be held by someone, you’re implicitly or explicitly making a decision to vary your portfolio composition from that of the overall market. But to be pragmatic, let’s accept that the broader indices are good proxies for the overall market. What decision then is left if you use index funds or ETFs for each asset class? The answer, of course, is asset allocation.
Asset allocation: what’s your benchmark?
The key criterion for selecting a benchmark is that it should represent an investable, passive alternative to the active portfolio we are considering. Within each asset class, if we choose to invest in the benchmark in the form of an index fund, rather than in the active portfolio, it does seem reasonable to say that we are passive in the sense that we engage in no security selection.
Now broaden the scope to the choice of weighting of each asset class. The standard practice is to have both a strategic and a tactical level. The weighting in the strategic asset allocation (SAA) is based on long-term estimates of risk, return and the correlation between the asset classes. The tactical asset allocation then represents any variation within a percentage band around the central weights of the SAA. It’s tempting then to see the SAA as the passive part, and indeed the practice is to use the SAA as the benchmark for TAA decisions. But is the SAA truly passive?
We typically modify it only very gradually, aside from rebalancing our weights back to their initial level when the performance of each asset class has made it drift. But it’s hardly passive in the sense that it involves no decision. It would, of course, have made a significant difference whether you held a fixed portfolio of, say, 60% in stocks and 40% in bonds or vice versa during the Great Financial Crisis, independently of whether you had used index funds, ETFs or actively managed funds. So, if the SAA represents decisions, shouldn’t it be subjected to a benchmark?
In some case we do have such a benchmark. Investors such as pension funds or life insurance companies have clearly identifiable liabilities which need to be matched by their assets in terms of risk and return. For most other investors, however, the best we can offer is some reference to semi-liabilities, like the need for retirement means, or calculations of the composition of the world portfolio of stocks, bonds, etc. None of these constitute the investable alternative which would make them an applicable benchmark. So we tend to pay more attention to relative risk than to absolute risk and focus on the performance of the TAA measured against the SAA. But that’s only half the picture.
The SAA alone approach
Even if you accept all this, you might still argue that TAA is a fruitless enterprise. Before commenting on this, let’s try first to place the burden of proof on the pure SAA approach, to borrow a term from the legal profession.
Avoiding TAA altogether of course implies shifting the level of decisions upwards and letting the outcome depend entirely on our ability to predict the long-term. The dominant view is that our ability to make return forecasts for time-horizons of, say, 10 years, is greater than our ability to do so for, say, the next 12-24 months. After all, over the longer-term we might decide to ignore the business cycle and can concentrate more on forward-looking models and asset valuations. Consider, in turn, the counter-arguments. Empirical studies have demonstrated a weak, or even contradictory, relationship between long-term economic growth and, for example, long-term equity returns.[ii] And a 10-year time-horizon may not suffice to ignore the business cycle. Whether our starting point is early-cycle, mid-cycle or late-cycle can matter greatly for the terminal value of our investment. Valuations do have a claim to some predictive power over the longer run, but some wide range between partial and full mean-reversion is about as certain as it will get. Then there is the issue of optimizing our portfolio. In order to benefit from diversification effects we need reliable inputs on asset class volatility and correlations between assets, apart from expected returns. The empirical fact is that these statistics tend to change dramatically over time, and long-term estimates are at best a very rough guide.
But surely, isn’t the shorter term even more unpredictable? Well, yes and no. To be sure, market sentiment will play a much greater role in the short run and changes in valuations tend to be more the effect than the cause of market swings. However, short-term asset class performance tends to show a much stronger relationship to the business cycle. Predicting cyclical turning points is no easy feat, but having a general grasp of where we are in the cycle allows us to ask the relevant questions and to hedge against the relevant risk factors. It also gives us a better handle on what will drive monetary policy decisions going forward.
SAA versus TAA: alternatives or complements?
There is a general drive towards shunning active investment management for individual asset classes and this trend may continue. Tactical asset allocation is less likely to be suspended. A really long time horizon, say 20-30 years, would perhaps justify ignoring tactical considerations altogether and focus entirely on empirically documented long-term asset class returns. But for most real-life investors this remains rather academic. Short term uncertainties will continue to see many lose faith in their long-term strategy, often at the worst possible time, and even institutional investors will be continue to be subject to the shorter-term focus of their sponsors. Tactical asset allocation is as much about managing risk over the investment horizon as it is about “timing the market” for higher returns. It therefore complements the SAA and puts investors in a better position to harvest longer-term risk premia. There are rational reasons why we should take it seriously.
Henrik Lumholdt is an adjunct professor at the IE Business School and the author of Strategic and Tactical Asset Allocation: An Integrated Approach (Palgrave-Macmillan, July 2018).
[i] Grossman, S. J., and J. E. Stiglitz. 1980. “On the impossibility of informationally efficient markets”, American Economic Review, 70(3), pp. 393–408.
[ii] See for example: Ritter, J.R. 2012. “Is Economic Growth Good for Investors?” Journal of Applied Corporate Finance, Vol. 24, No. 3, pp. 8-18.