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Passive investing is about sticking to a process, not the process itself.

(From the latest Value and Momentum Monitor)

Passive investing can be defined as following a set of strict rules, defined in advance. Most would say that passive investing means indexing, but that’s just passing the buck, because an index must be defined and managed. The question remains, what rules are you following, and why? The Dow was invented by newspapermen in 1885 to give readers a snapshot of NYSE performance. It was not designed as an investment vehicle, but for convenience. Share price weighting meant all the WSJ needed was the daily close, not the share count. Nonetheless, because the modern Dow is 30 stocks across several industries, even with its effectively random weighting it has been more or less interchangeable with the more diversified, market cap weighted S&P 500.

The S&P 500 wasn’t designed as an investment vehicle either, as there were no index funds prior to Vanguard’s founding in the 1970s. It too was only meant to be a gauge of average market performance, and as such, it is flawed as an investment strategy. Over at least the last three decades, market cap weighting has cost an average of 1.5% per year relative to equal weighting, as the largest companies simply don’t have the same capacity for growth as smaller ones. But it gets worse: in a likely effort to accommodate more assets in index funds, S&P started weighting by public float, which effectively underweights stocks with higher insider ownership.

The only good reason to invest in a price, market cap, or float weighted index is because the alternatives are often far worse, such as high-cost mutual funds or naive discretionary investing. Naive discretionary investing is a miasma of untested hypotheses deployed without rubric or risk control, in other words, the portfolio of your typical CNBC-watching, Barrons-reading, DIY investor. The performance of such investors forms a very wide distribution with an average that lags the market by over 6% per year, with a long, bulging left tail. In the context of that very real risk of ruin, random-weighted and float-weighted indices start to look very attractive.

Recommending SPY, DIA, or VTI is a no-brainer for investment advisors and financial writers. Such index funds are a cheap and easy way for anyone to become an equity owner in a basket of mature, profitable companies. They can be expected to deliver 3-7% returns including inflation and dividends over the long-term, far in excess of cash, and involve little risk of ruin for a buy-and-hold investor who avoids leverage and balances them with a quality bond fund.

But what if a strategy’s capacity isn’t a concern, as for us as individuals and small firms? In that case, we can decide on a set of rules (and let’s use hard and fast rules to keep us out of our own way) not to gauge performance but to deliver it. This is what fundamental-weighted indices do, overweighting companies with better balance sheets and lower valuations. Is the buyer of such an index fund still a passive investor? Of course. But what if he buys a data feed, runs the same screens himself, and buys the shares directly? Is he still passive? What about if he tweeks the parameters? Anyone can create an index (I’ve made and tracked several myself), so it is not passive investing in and of itself that must be evaluated, but the underlying rules.

Simply having rules is a huge leg up, for two main reasons: They can be tested on historical data, and they take our emotions and biases out of the investment process. I still encourage the average, low-effort investor to buy the S&P, because simply having rules, even sub-optimal ones, is better than naive discretionary investing. I would even argue that all discretionary investing is naive, as any investment process can and probably should be written down as hard and fast if-then statements. There is no shame in abdicating your process to an algorithm – after all, it’s your process and you build the algorithm. If you actually know what your process is, you can explain it simply, and if you can explain it simply you can code it. This ensures that your process, which presumably offers some edge or other desirable characteristics, is followed month-in, month-out, even when your personal life is distracting or the financial news is disconcerting. Any investment process worth following will be improved by the removal of human bias and whim – the more passive the investor, the better the result.

Passivity means submission to a process, nothing more. Once you decide to remove your emotions and snap judgements, the question is simply which process to follow. A little reading and exploration will go a long way here. There is certainly a form of safety in the contemporary consensus of the S&P and the Barclay’s Aggregate Bond Index, not because that strategy is especially strong, but that it has at least delivered adequate results for a long time. And if you are the kind of person who seeks safety in numbers, you’ll find plenty of company in a 60/40 portfolio of those indices.

But if you trust in your ability to discover the best option available, and you don’t need or want a lot of unsophisticated company, you can follow a better process. Simply using an equal weighted stock index would be an improvement, as would be additional asset classes, such as foreign stocks, REITs, and commodities. An additional step that dramatically improves results is a momentum filter applied to each asset class or to each stock within the equity portion of the portfolio. Such a filter is simply another predeterimed rule to be passively followed. If this is active investing, then so is the maintenance of a major index, as stocks are weighted, added, and removed according to all manner of far less transparent rules.

In conclusion, examine your investment process, its risks and returns. If the process suits you, follow it. If not, find another. Read widely, and use your personal judgement, but set it aside once you make your selection and set your process in motion. Then relax, put aside the financial news, and read an old book.

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