Category Archives: Passive Investment

Some of You Will Sell or the Achilles Heel of the Arithmetic of Active Management

I’ve made no secret of my fascination with the active/passive debate. I don’t have a dog in this fight: my perspective is that of an active individual DIY investor. There is strategy diversification in my own portfolio: 40% of my total portfolio is in what I call a “passive strategy” where the equity allocation consists entirely of low-cost index funds; nearly all of the rest is in an “active strategy” where the equity allocation consists of individual stocks. However, since this secular change from active to passive has the potential to affect security pricing and the persistence of trends everyone should care deeply. Last time, we took a look at possible float manipulation, today the attention is on the corner stone of the argument for passive indexing. I don’t think I came close to disproving it, only weakened it by considering real people who make suboptimal decisions. That seemed appropriate in a year when the father of behavioral economics won the Nobel memorial prize.

Risk Tolerance or Why People Sell at Bottoms

A typical questionnaire for an investor’s risk tolerance includes questions such as: “If the stock market drops 30%, will you A) Sell everything, B) Sell half, C) Do nothing, D) Buy more stocks”. In my opinion, these questions are worth less than the paper they’re printed on. People don’t sell because the market has dropped 30%; they sell because after the 30% drop the market looks to be dropping another 30% ‐ a virtual certainty according to the perma-bears whose advice they wish they had heeded. In addition, serious market declines often don’t not appear out of thin air, rather they tend to be accompanied by real economic malaise: in 2000-2002 it’s the mal-investments of the dot com era and closure of countless “new economy companies” and those that service them; in 2008-2009 it was the collapse of the housing bubble and the veritable brink-of-collapse of the global financial system. Imagine the following scenarios and ask how many would sell:

  • A nuclear attack on US soil.
  • US losing its superpower status which has underwritten its prosperity since WWII.
  • Total collapse in Japan/EU. Sovereign debt crisis. US 10Y treasure yields above 5%.
  • Banking crisis, bank bail-in
  • Wide spread job loss including one’s own

This is not at all a prediction that any of the above may actually happen, but rather that a questionnaire or even thoughtful introspection during times of peace and prosperity can never capture the emotional and psychological stress investors will be under in a real economic crisis. Time and again, many who know they should, and think they can hold through a bear market ended up selling at the worst time. In fact wide-spread capitulation is a prerequisite for bear-market bottoms. Nobody sells? Fine, the bear market continues until a lot of people do — this is the way it works.

Time Horizon for Most Investors is Shorter Than Expected

The long term stock market average is often plotted as an uninterrupted bottom-left to upper-right squiggle. “In the long run, stocks always go up.” is the prevailing mantra. The rub is the definition of the “long run”. As I discussed in The Arithmetic of Prudence, for a typical worker saving for retirement, what really matters is the the return during two decades — one on each side of the retirement date. During the accumulation phase, the money weighted return necessarily depends more on when the portfolio value is greatest, i.e. near retirement. The closer the investor is to the distribution phase the less he can rely on the “long run”, the less he can afford to suffer through a severe draw down. Success of the withdrawal phase largely depends on the period immediately after retirement, i.e. the dreaded sequence of return problem. No matter how one slices it, two decades is not long term given the natural gyrations of the stock market. The standard recommendation of “invest for the long run” should be understood as an expediency — most people are even more terrible at being a short term trader — than a truth.

Note that on average there is 1 bear market per decade (source).

The Arithmetic of Active Management and Its Achilles Heel

Nobel laureate William Sharpe made the observation that in the aggregate active investors and passive indexers must both own the market portfolio, hence the passive indexer must outperform, in the aggregate, due to lower fees. That is the gist of the arithmetic of active management. It’s tautologically true and has proven to be the bane of active fund managers everywhere. I have only seen this argument applied to stocks and that’s where our discussion will remain.

Index funds are a great invention and Jack Bogle deserves all the accolades going his way. I’m all for the little guy getting the most he can and sticking it to the banksters in the process. It can only be a good thing if LBYM, invest early and often, passive indexing become part of the ethos &mdas; Americans consume too much and save too little IMO. However, thinking individuals must also realize there is no such thing as an unmitigated good: by-passing financial advisors and active management also removes gate keepers and return dispersion during bear markets. The issue with the popularity of index funds is the synchronicity of selling and the echo of negative emotions during market duress. Even die-hard Bogleheads readily admit it is not easy to hold through a bear market (thread 1, thread 2). As the democratization of investing via passive indexing gathers more adherents we can expect a fair number to lack the fortitude to hold through a down turn. Such is the Achilles heel of the arithmetic of active management if there ever is one: the passive indexer must hold the market portfolio to earn the market returns; if he sells, all bets are off.

Let me recast this argument which I’ll call the Corollary of the Venditor (Latin: seller).

  • In general and among the passive indexers there are two types: type A who holds through market ups and downs; and type B who makes poor timing decisions: hesitates to buy when the market is trending up, and/or sells at market bottoms.
  • Type A indexers receive market returns; type B indexers must receive below-market returns on account of their poor timing.
  • Therefore, passive indexers as a whole receives below-market returns.
  • Active investors who make up the rest of the market, must receive above-market returns equal to that surrendered by the type B indexers.

It’s not necessary to estimate the proportion of type A and B indexers, only that B is non-zero. There are type B active investors as well, but their losses accrue to other active investors not type A indexers. Nothing above dictates how the return among active investors is distributed. This is not a defense of actively managed funds with high fees that eat into investor returns. The obvious recommendation for passive indexers is not to be distracted by emotions but that’s like saying everybody should eat healthy and exercise. Lastly, the net alpha of active investors comes from poor timing decisions of some passive investors, in other words timing counter to type B investors is a path to above-market returns. This counter move can be achieved by allocation adjustment during bull/bear markets, market timing in the traditional sense with active managed funds, or even market timing with index funds (I know you were wondering where these guys are).

In summary, I believe the Corollary of the Venditor points to an a priori opportunity for the aggregate active investors to achieve above-market returns. The advantage is probably not large enough to overcome the fees of active fund managers per SPIVA records but the active individual investor can claim his due by: cost-reduction (fees, trading and taxes), differentiated positioning (concentration, factor tilts, active share), and above all adaptation to macro cycles that occur on the order of years or a decade. These are precisely the things I practice and write about in this blog.

This post is not meant to be a detraction of passive indexing which is still the best recommendation for most people. Type B investors exist irrespective of the investment vehicle so they may as well pay less fees while invested. Studies have shown small out-performance by active mutual funds before-fees and now we have an explanation for it being a systemic effect. With that we can reject the more fundamentalist passive indexers who claim there is only one way to invest, who also tend to be over-allocated to equities. Though I remain grateful — a fair number of them and their converts will end up being type B investors without whom people like me will have diminished hope of out-performance.


  1. Sharpe, W. “The Arithmetic of Active Management.” Financial Analysts’ Journal, Vol. 47, No. 1 (1991), pp. 7-9. Link
  2. Pedersen, L., “Sharpening the Arithmetic of Active Management” (2016, SSRN 2849071) Link Talks about the effect of trading.
  3. Vertes, D., “Active vs. Passive Investing and the ‘Suckers at the Poker Table’ Fallacy” Link I believe is saying the same thing, but boy is it a long read.

Passive Indexing and Float Manipulation

I have said multiple times in this blog that Bogleheads is one of my favorite investing forums — to read but never to post. There are many posters with deep understanding not jut in finance but also in many other areas of life willing to share their knowledge. But there is also a visible group with the “holier than thou” attitude for whom ignorance is displayed like a badge of honor. Not understanding something therefore choosing not to act is perfectly sane and prudent, and I’ll never hold anything against anyone for that. Not having the curiosity or the willingness to learn new things though is a fatal character flaw and a source of so much that is wrong in our society.

In this post I want to highlight two Bogleheads threads about whether passive indexing, as it becomes ever dominant, distorts markets and pricing, as well as if there are ways to take advantage of its dominance.

Our protagonist is user jbolden1517. I don’t know him (I assume it’s a he) personally but from his writings can surmise that he’s an investment professional and has been active since at least before the great financial crisis. I have an enormous amount of respect for him for no other reason than the amount of patience he displayed explaining things to a skeptical audience. jbolden1517 outlined a process of “float manipulation” where controlling shareholders can use index funds as a source of cheap financing:

User jbolden1517:

The real problem for indexers is float manipulation. If 70% of a stock’s float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I’m including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing. In a normal market, in CAPM’s theory investors are rationally pricing stocks based on their future discounted dividends using a discount rate that adjusts for risk. So under CAPM doubling the number of shares merely cuts the share price in half. Doubling the number of shares should have no impact on market cap. But of course index funds don’t rationally evaluate the future stream of dividends. Indexers hold a constant portion of any stock, buying or selling based on float not dividend prospects. So when the number of shares double they have to slowly raise they buy target till they get the shares back in balance. This is the same thing that happens to short investors in a short squeeze. They will end up paying far more than the company is worth.

User nedsaid finally getting the point:

So it is basically a game of now you see it, now you don’t. Those shares are technically float because B of A owns them, but not really. It sounds like what Company X does is over time release additional shares from its Treasury stock (stock it had previously purchased on the market reducing outstanding shares) to meet demand from the index funds. So Vanguard has to buy shares based on shares that are technically outstanding but not really because they are owned in synthetic fashion by B of A. What is being sold to the index funds is not B of A’s stock in Company X, but Treasury stock from Company X released incrementally to meet index fund demand.

The second thread contains discussions on inflows which is another way of looking at this crucial problem: what is the amount of trading due to passive index funds relative to those responsible for price discovery? Estimates today are that 35% of the total market capitalization is in index or closet index funds. Though this figure may not have any bearing on the composition of trade volume on any given day. According to this report from NYSC, for Q4 2016, U.S. ETF dollar volume represented approximately 29% of all consolidated tape issues in 2016. The vast majority of ETFs are cap-weighted indexers. We also need to keep in mind that there are also quant funds that “don’t read the earnings report” to use a phrase used by jbolden1517. He quoted a report from JPMorgan that 3/7th of the trading volume is from indexers, 3/7tg arbitrage and 1/7th fundamental. I have not been able to find a link to that report; however, the most recent memo from Howard Marks seems to confirm this:

Raj Mahajan of Goldman Sacks estimates that already a substantial majority of daily trading is originated by quantitative and systematic strategies including passive vehicles, quantitative/algorithmic funds and electronic market makers. In other words, just a fraction of trades have what Raj calls “originating decision makers” that are human beings making fundamental value judgments regarding companies and their stocks, and performing “price discovery” (that is, implementing their views of what something’s worth through discretionary purchases and sales).

Another piece of corroborating evidence can be found in the most recent Masters in Business podcast (Barry Ritholtz interviews Katie Stockton), there was a brief exchange starting around the 7:00 mark about the volume no longer being a good technical indicator which was attributed to index and quant funds.

My Own Thoughts

40% of my portfolio is passive, utilizing cap weighted index funds exclusively for the equity component. I see index funds as the most widely available, cost-efficient (in ER and time/energy) way of getting equity exposure. However, I also recognize their weaknesses which I discussed here. Lacking access to relevant data or studies, it was a purely mental exercise for me. So I was happy to have found a kindred spirit in jbolden1517‘s writing. In my own post, I was a little hazy on the “control share holder” aspect. An idea occurred to me after reading Eric Cinnamond’s The Passive Investor (PI) Ratio: a hedge/private equity fund could acquire a company with a high PI ratio and apply the float manipulation technique to use the index funds as its exit strategy.

In the spirit of intellectually honest exploration I want to present opposing views on the issue of trading volume attributable to fundamental discretionary traders. On one hand, there seems to be evidence to support the figure of 1/7th of trade volumes. It was probably 100% at one point in history, so 1/7th would be a big reduction. On the other hand, who is it to say it’s insufficient for price discovery? I don’t think anyone knows for sure. One other piece of data we may want to take into account is that the internal market correlation is a a low (source), although it could just be a sign of a top (source). In the end, I’m leaning towards there probably isn’t a big effect now but we’re probably closer to that point than most realize.

Defenders of passive indexing will rightly ask, what are the demonstrable ill effects of all these? The only possible answer is: very little to none, TODAY. It is no reason to be complacent, however. Imagine a real estate investor confronted with the malpractices in mortgage lending in 2005 and asking to see evidence of national housing price declines — there are real dangers in ignoring the warning signs.

I expect the migration to passive indexing to continue, consistent with my stock market projections. It’s a self-reinforcing cycle: more buy-at-any-price investors will prolong the bull market which tend to improve the relative performance of index funds over actively managed funds that limit their exposure, which leads to more passive indexers. While the trend is underway, it’s foolish to stand in front of it. At the same time, all the excesses and distortions will continue to build, providing opportunities when the trend finally turns. To me market timing in accordance with these trends is the most logical response.

Passive Account Asset Allocation, May 2017

In the most recent market commentary, I reiterated the view that the final phase of this correction was due to start in May and events in early May might serve as external triggers. Reality again strains the limits of patience: market-friendly outcomes from the the FOMC meeting and French election propelled S&P above the March 1st high before the “constitutional crisis” surrounding Trump’s firing of the FBI director James Comey precipitated a one-day 43-S&P-points drop on Wednesday. There was a lack of follow-through however. Although I still believe there will be a final drop, I’m not sure if even 2320 on the S&P is “in play” at this point.

One may rightly ask why the correction has been much shallower than anticipated. It’s easy to come up with conspiracy theories where the Central Bank or the plunge-protection-team (PPT) surreptitiously support the market to accomplish their policy objectives. It may be true, but this is one area where I consciously decide not to have an opinion. Not “I don’t know” but “I don’t want to know” — an intentional burying-head-in-the-sand that not everyone is willing to do. Besides deliberate intervention, it’s possible that there are enough other market participants also poised to buy the dip, or the stream of passive buy-no-matter-what crowd is so overwhelming. The question itself is misplaced, it’s not about why but is. The only conclusion to be drawn is that when something refuses to go down it will go up with a vengeance. Anything else is an opinion, ideology even, that I can’t afford.

Throughout this month, I have been steadily deploying cash into the buy-list, but there is still some ways to go. I have also been looking at the asset allocation in the passive accounts. My current plan is to further increase the equity allocation by another 5%. For reference, the current AA is 50% equities/35% FI/15% PM, I’ll move into the AA under the “Aggressive” heading below, shifting out of FI.

The composition of the subclasses are limited by access to funds rather than from any quantitative analysis. I can only access EM, and REITs in my Roth IRA accounts while the LB, SB and total international from HSA and 401K that see regular contributions. So they end up taking all of the increases. The overall portfolio will be at 55-60% equities by the end of the summer. This is at least 10 percentage points higher than my baseline allocation were there not the belief that we’re in the final bubble phase of this bull market. For reference, I also outlined what a “defensive” AA would look like. Keeping the PM allocation constant at 15%, there is a 15% overall shift between equities/FI. The composition of the subclasses is also different as the emphasis is to reduce risk and take advantage of the negative correlation offered by treasuries. Of course a new plan will be needed if the next crisis is triggered by a flee from US government bonds. I still see a likely transitioning into the “defensive” AA in Q3’18.

Performance Tracking January 2017

For calculation methodology see earlier post

2017 started with a bang — precious metals performed well even though it was looking to retest the 2015 lows at the end of last year. Since PMs are the main drivers in the “tracking error” (I hate that term!), my portfolio did well relative to the overall market. The S&P also had a good month, gaining 1.79% while the bonds gained 0.21%, meaning the benchmark 60/40 portfolio picked up 1.16% for the month.

Passive Portfolio

The total passive portfolio gained 2.11%, the portion outside of the 15% allocation to PMs gained 1.34%. In this post, I outlined my plan to increase the equity allocation by 5%. I’m about half way done. Funds has already come out of TBM but has not been added to equities just yet. The market has been directionless for a long time. Since the model has a low in February and I know it can’t be timed perfectly, I have already started to transfer funds slowly. I can only access the emerging market index fund, VEMAX, in a Roth IRA at Vanguard and the space is limited. Hence I had to dial down its allocation by 1% and shift to VTIAX. The allocation for the rest of 2017 looks like this:

Active Portfolio

The overall active portfolio gained 2.37% despite the drag from DGI whose main culprits were victims of presidential tweets and Target. Large changes are being made in FI: reducing muni CEFs in taxable and adding to taxable CEFs in taxed advantaged. I’m using this opportunity to cull back certain dividend stocks.

Plan and Forecast

Transition to my AA is straight forward and should be completed by the end of February. In the active portfolio, the goal is to maximize tax advantaged space for taxable CEFs. Consequently, dividend stocks will all end up in taxable. Tax considerations alone forces me to favor stocks with high dividend growth over high current payout. Currently, the blended payout ratio for my DGI stocks is 2.74% vs. 2.03% for SPY and 2.93% for VXUS. I expect this ratio to come down further. I’ve also started positions in MKL, aka “the baby Berkshire”. It doesn’t pay any dividends so doesn’t count towards DGI. I’m taking my time to buy the taxable CEFs as they have all been on a good run — patience is definitely a virtue. This process may continue well into March or April.

Portfolio Changes 2017

A new year is always a time for reflection and planning for the future. This is especially true for one’s investments. My investment policy statement (IPS) allows for a once-a-year plan review and gradual changes in my passive allocation. Those changes don’t have to be implemented right away and can subject to a range of dates or pre-conditions. The important thing is to keep a record of them and hold myself accountable.

2016 Results

I was quite happy with the portfolio level gains in 2016: 10.87%. It was calculated with the Simple Dietz method which meant contributions were properly accounted for. One of my pet peeves for many personal finance blogs is the co-mingling of contributions and investment returns. Another widely used formula is (end value – start value – contributions)/start value. It’s generally fine except when the contribution is large. The simple Dietz method adds half of the contribution to the denominator to approximate the time-weighted return. The 10.87% figure was calculated on an annual basis, more accurate would be to chain link monthly figures. Unfortunately the official record for this blog was only started in August. I’ll have much more data to work with in the future.

AllocateStartly had a summary of various allocation strategies for 2016. The Golden Butterfly portfolio which I drew inspirations from was the top dog at 10.79%, while the benchmark 60/40 portfolio returned 7.71%. So it doesn’t seem I have much to complain about. Though in all fairness I took on more risk — I have silver/miners in my PM sector, my equities are higher and cash position lower. Conversely, the equity slice-and-dice to include international hurt my returns. The timing of the start of this blog was unfortunate as July was the high watermark in terms of percentage gains. I gave back more than 3 points in the 2nd half of the year while the S&P was going gang-busters, so the results from August look rather poor. I’m an unabashed market timer, so that’s definitely something to improve on.

A New X

I have no plans to disclose actual dollar amounts — I hope it doesn’t detract from the ideas discussed here. At times I have spoken about the portfolio value in terms of X, where X is my non-inflation-adjusted, no-mortgage, target annual pre-tax retirement income. More recently, after some thought about desired life-style and future medical expenses, I’ve decided to increase X by about 10%. I don’t foresee any further changes to this figure.

Current investible assets stand at 17X after a contribution of 1.3X and a gain of 1.6X in 2016. I define “financial independence” as 25X plus a paid-for primary residence. There is still 4.5X left on the mortgage. Being naturally conservative I’ll probably keep working until reaching 30-35X. This amount will also include any future financial support for my daughters. There’s definitely some margin of safety in X, such that I call investible assets at 20X “financial independence lite” even without paying off the mortgage. It’s tantalizingly close, with luck may even be reached in 2017.

Passive Allocation

My guiding assumptions for the next couple of years are based on an equity pricing model I have been following. So the plan is to increase the equity allocation slightly after a drop in the market in the first quarter.

I’ll maintain the 50/50 split between US and international and increase the overall equity allocation by 5% which comes out of TBM. No changes in PMs.

Active Portfolio

The active and overall portfolios don’t follow a set allocation, although I do check it for risk management purposes. The overall equity allocation may grow to 55% by the end of 2017 from 50%. I expect the DGI portfolio that is heavy in consumer staples to under perform the broader market but don’t plan to make any major changes. Additions to the DGI will likely be old tech (MSFT, QCOM, CSCO), or a high-growth, low payout name like V. I plan to add more to growth stocks, currently at 7% of the active portfolio, and bring it up to 10%.

Option writing was a reasonably successful endeavor last year but my activity tapered off as job responsibilities increased. It’s still something I plan to continue this year, although I don’t have a target in mind. It is reassuring to know that if I ever lose my job I can generate some income this way. I do plan to use more synthetic equities (buy call, sell put) as a means to increase leverage. More details will follow when I open such positions.