Investing Based on Evidence: The Global Market Portfolio, Earth's Financial Portfolio.
The dispute between proponents of passive and active investments creates significant confusion. What characteristics must a financial portfolio have to be considered "passive"?
More and more often, you'll hear repeated claims that active management, on average, fails to outperform the market. Therefore, it's increasingly rational to resort to passive management. This involves subscribing to indexed financial instruments, which do not aim to "beat" the reference market, but to mimic the reference market's performance.
On the opposing side are those who argue the contrary – asserting that there are managers (or strategies) who systematically manage to outperform the reference market. Thus, they suggest it's more advisable to identify these individuals rather than settling for average market returns.
This is a genuine clash, often marked by heated tones, that has persisted for decades, and this contribution does not intend to fuel it.
I believe it's much more interesting to delve into the true meaning of "passive investment".
Let's consider an investment portfolio composed of two Exchange Traded Funds (ETFs), for instance, with 60% invested in an equity ETF and 40% in a bond ETF. Is this a passive investment portfolio? Once the initial allocation is defined, the portfolio undergoes periodic maintenance (known as "rebalancing"), triggered whenever stocks appreciate in comparison to bonds, or vice versa. This process maintains the originally defined 60/40 ratio. Deciding to invest 60% in stocks and 40% in bonds via ETFs and actively working to maintain these percentages over time – is this an active or passive investment strategy?
What if the portfolio used four different ETFs representing four distinct asset classes (e.g., 20% stocks, 40% bonds, 20% gold, 20% real estate)? What about using ten ETFs? Are we then employing the most suitable financial instrument (ETF) to construct a passive investment strategy and, furthermore, are we actively striving to preserve the initial allocation through periodic rebalancing? Could it get more "passive" than this?
Regrettably, even the most fervent proponents of passive investment strategies appear to lack clarity on this when they consider using ETFs as both necessary and sufficient to construct a passive investment strategy.
Let's return to the earlier example of a portfolio with four ETFs: 20% stocks, 40% bonds, 20% gold, 20% real estate. In this case, am I using indexed instruments in these proportions, which passively replicate their respective indices, relinquishing any intention to surpass them. Again, does this categorize me as a passive investor?
Consider for a moment; why did I choose to invest exactly 20% of the designated funds into stocks? And why precisely 40% into bonds (replace these percentages with any you might have encountered in articles, blogs, your bank's proposals, or your consultant's advice)?
Deciding these percentages is a "highly active" decision, as it will have the most significant impact on the long-term returns an investor obtains from their financial portfolio [1].
For those who, too simplistically, advocate the superiority of some vaguely defined passive investment strategy, it might seem enough for the portfolio to consist of ETFs (or other low-cost indexed instruments) to consider it passive management.
However, merely passively replicating one or more indices doesn't suffice to deem the portfolio as a whole "passive"; the percentages at which my portfolio is exposed to each asset class must also be "passive" (excuse the wordplay).
In other words, the allocations to individual asset classes (as mentioned earlier, stocks, bonds, commodities, gold, real estate, etc.) must replicate those of a portfolio that can be objectively considered genuinely passive.
This portfolio does exist, and it's called the Global Market Portfolio (GMP). Introduced by two Nobel laureates, Markowitz [2] and Tobin [3], who defined it as a "super-efficient portfolio" perfectly balancing risk and return, it was later identified by William Sharpe (also a Nobel laureate) as the portfolio encompassing all financial assets weighted by their market values [4].
How is the GMP composed? Below is a representation based on specific academic research on the topic [5]:
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The GMP, at least for those who advocate market efficiency, is the portfolio that, for a given level of risk, offers the highest return. Maintaining the GMP doesn't require rebalancing. Instead, one should periodically consult academic literature to ensure the weights remain aligned.
For instance, in the graph below, it's clear that some portfolios (or individual asset classes) offer higher returns but also entail higher risk.
The GMP, in other words, is the most efficient portfolio for an investor who believes in market efficiency and who deems that they don't possess any information that the market doesn't already know or hasn't already priced in.
Now, let's address the essential point that the eternal and inconclusive clash between active and passive management has, astonishingly (deliberately?), overlooked.
Intentionally or otherwise, holding an investment portfolio different from the Global Market Portfolio implies assuming that you possess information, estimated returns, and volatility (or risk) of each individual asset class (stocks, bonds, commodities, etc.). In essence, it assumes that you are capable of deciding the initial allocation and the subsequent frequency and nature of the "maintenance" of the financial portfolio, based on scientific evidence no less qualified than the evidence underlying the GMP.
If this isn't the case, i.e., if you don't consider yourself capable of making these estimates, the most rational choice should be to invest in the GMP.
Attempts to enhance the efficiency of the Global Market Portfolio, the passive portfolio by definition, are certainly legitimate but must be considered active management in every sense, even when employing ETFs to replicate reference indices.
In summary, the distinction between active and passive management is far more nuanced than one might believe, and the informed investor shouldn't settle for either generic claims alluding to supposed abilities to "beat the market" or, even more so, be content with the generic assurance that the mere use of indexed instruments is synonymous with scientific rigor in investment choices.
The Global Market Portfolio serves as a beacon, an anchor that should compel every informed investor to inquire and demand detailed, evidence-based documentation of the investment protocol their wealth/asset manager intends to employ when assisting and advising them on long-term investment decisions.
This is the essence of Evidence-Based Investing: investing based on evidence.
Luca Cirillo | Consulente Finanziario
[1] The True Impact of Asset Allocation on Returns (Roger G. Ibbotson).