the ongoing "active" vs "passive" debate

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
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Bylo Selhi
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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 28 Apr 2013 11:15

I'm not claiming that market weighting always outperforms. I'm challenging the case for equal weighting, especially after accounting for frictional costs.

As for "going with sub-optimal diversification via the market cap route" where's the case that equal weighting is any less sub-optimal, again after accounting for frictional costs?
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 28 Apr 2013 12:00

kcowan wrote:]And also to keep a fair and balanced perspective in FWF and keep our varied readers interested in threads like this.
Indeed.

I'm very grateful to those who present an alternative viewpoint. I argue strongly for my viewpoint, because I think I am right, but I recognize that I may be wrong. It's important to me to hear different opinions, the more vigorously argued the better. As a result I may change my mind, or shade my upinion, or be confirmed in what I believe. In any case, it will make me review what I think I know.
NormR wrote:Ok, I hear some folks saying they come close to market cap weighting in equities. I hear no one talking about bonds. Nor the split between bonds and stocks. Given the huge size of the bond market compared to the stock market, I suggest that no one is even close to market caping their portfolio. Indeed, on the bond side all sorts of non-market cap stuff seems to go on.
A very good point.

In my case, I run a "barbell" portfolio. One of the "balls" is a portfolio of equities, or rather ETFs, designed roughly along market cap lines. This is what is supposed to produce growth in wealth (track the upward drift in the Brownian motion). The other "ball" consists of the safest instrument I can find, in my case RRBs. The weighting of RRBs versus equities has nothing to do with market caps. It has everything to do with risk control. As I grow more risk averse with old age, I shift the fulcrum of my barbell, to use a mangled metaphor, so that there are fewer equities. Nothing to do with market capitalization.

I dunno the amount of bonds outstanding, and I'm not sure it is even relevant. A lot of debt never gets securitized and so would not show up, but would constitute a close substitute. So a market cap of bonds is meaningless, and a market cap of debt is impossible to calculate, and would also probably be meaningless.

Still, an interesting idea for a paper. :wink:

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Re: the ongoing "active" vs "passive" debate

Post by NormR » 28 Apr 2013 12:57

ghariton wrote:
kcowan wrote:]And also to keep a fair and balanced perspective in FWF and keep our varied readers interested in threads like this.
Indeed.

I'm very grateful to those who present an alternative viewpoint. I argue strongly for my viewpoint, because I think I am right, but I recognize that I may be wrong. It's important to me to hear different opinions, the more vigorously argued the better. As a result I may change my mind, or shade my upinion, or be confirmed in what I believe. In any case, it will make me review what I think I know.
Some of us just argue to see where the different sides of the argument fail. It can be a highly informative endeavor. 8)
ghariton wrote:
NormR wrote:Ok, I hear some folks saying they come close to market cap weighting in equities. I hear no one talking about bonds. Nor the split between bonds and stocks. Given the huge size of the bond market compared to the stock market, I suggest that no one is even close to market caping their portfolio. Indeed, on the bond side all sorts of non-market cap stuff seems to go on.
A very good point.

In my case, I run a "barbell" portfolio. One of the "balls" is a portfolio of equities, or rather ETFs, designed roughly along market cap lines. This is what is supposed to produce growth in wealth (track the upward drift in the Brownian motion). The other "ball" consists of the safest instrument I can find, in my case RRBs. The weighting of RRBs versus equities has nothing to do with market caps. It has everything to do with risk control. As I grow more risk averse with old age, I shift the fulcrum of my barbell, to use a mangled metaphor, so that there are fewer equities. Nothing to do with market capitalization.

I dunno the amount of bonds outstanding, and I'm not sure it is even relevant. A lot of debt never gets securitized and so would not show up, but would constitute a close substitute. So a market cap of bonds is meaningless, and a market cap of debt is impossible to calculate, and would also probably be meaningless.
Wow, you really threw market-cap weighting for bonds under the bus there. Why the difference compared stocks? After all, there are a good number of private companies that can't be purchased. Are bond index funds a bad idea?

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Re: the ongoing "active" vs "passive" debate

Post by NormR » 28 Apr 2013 13:00

Bylo Selhi wrote:I'm not claiming that market weighting always outperforms. I'm challenging the case for equal weighting, especially after accounting for frictional costs.

As for "going with sub-optimal diversification via the market cap route" where's the case that equal weighting is any less sub-optimal, again after accounting for frictional costs?
Start with equal weighting then do nothing. It solves the friction problem.

Speaking of friction, why aren't there more index products that avoid dividend paying stocks?

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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 28 Apr 2013 13:22

NormR wrote:Start with equal weighting then do nothing. It solves the friction problem.
How so?

An equal weighted index fund has to reconstitute itself regularly as underlying stock prices change. That means selling and buying shares of the underlying stocks. Assuming that the index rises in value over time then this means investors get capital gains distributions. (Worse with non-Canadian ETFs these distributions are characterized as ordinary income for Canadian tax purposes. Thus they're taxed at about twice the rate that they would be if they arose from the sale of ETF shares, where they'd retain their CG characterization.) Investors also pay the trading related costs of reconstitution (brokerage fees, spreads, stamp taxes, etc.) Then on top of all that are the substantially higher MERs charged by equal-weight ETFs compared to their market-weight equivalents.

With market cap weighting some friction still remains. But it's much lower than with equal weighting. This is a hurdle that equal weighting has to overcome every year in order to beat market capping.
Speaking of friction, why aren't there more index products that avoid dividend paying stocks?
Don't give ETF purveyors even more ideas for boutique indexes that allow them to charge even higher MERs to "hot money" investors :twisted:
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Re: the ongoing "active" vs "passive" debate

Post by NormR » 28 Apr 2013 13:43

Bylo Selhi wrote:
NormR wrote:Start with equal weighting then do nothing. It solves the friction problem.
How so?

An equal weighted index fund has to reconstitute itself regularly as underlying stock prices change. That means selling and buying shares of the underlying stocks. Assuming that the index rises in value over time then this means investors get capital gains distributions. (Worse with non-Canadian ETFs these distributions are characterized as ordinary income for Canadian tax purposes. Thus they're taxed at about twice the rate that they would be if they arose from the sale of ETF shares, where they'd retain their CG characterization.) Investors also pay the trading related costs of reconstitution (brokerage fees, spreads, stamp taxes, etc.) Then on top of all that are the substantially higher MERs charged by equal-weight ETFs compared to their market-weight equivalents.

With market cap weighting some friction still remains. But it's much lower than with equal weighting. This is a hurdle that equal weighting has to overcome every year in order to beat market capping.
Don't do it in a fund but via a low-cost brokerage. Start with equal weights then let things grow and you'll slowly become slightly more market cap weight. Cut out funds entirely. Don't pay those greedy people at Vanguard. You'll avoid needless index rebalancing. It's easier to do in Canada, but buying 100 stocks isn't out of the question in the U.S. and that's all it seems to take.

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Re: the ongoing "active" vs "passive" debate

Post by ig17 » 28 Apr 2013 14:20

NormR wrote:It's easier to do in Canada, but buying 100 stocks isn't out of the question in the U.S. and that's all it seems to take.
How critical is 100?

Global Industry Classification Standard includes 10 sectors. Buying 4-5 companies in each sector (40-50 total) ought to be enough to track S&P500 reasonably well (never mind beat it).

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Re: the ongoing "active" vs "passive" debate

Post by NormR » 28 Apr 2013 15:01

ig17 wrote:
NormR wrote:It's easier to do in Canada, but buying 100 stocks isn't out of the question in the U.S. and that's all it seems to take.
How critical is 100?

Global Industry Classification Standard includes 10 sectors. Buying 4-5 companies in each sector (40-50 total) ought to be enough to track S&P500 reasonably well (never mind beat it).
Simply put, I don't know. 25 is likely too few, but 50 might work with a sector approach. You'll likely boost volatility and tracking error with the index as the number of stocks fall. But 100 isn't a particularly special number.

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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 28 Apr 2013 16:17

NormR wrote:Don't do it in a fund but via a low-cost brokerage. Start with equal weights then let things grow and you'll slowly become slightly more market cap weight. Cut out funds entirely. Don't pay those greedy people at Vanguard. You'll avoid needless index rebalancing. It's easier to do in Canada, but buying 100 stocks isn't out of the question in the U.S. and that's all it seems to take.
1. That's neither an equal nor market weight ETF. It's a third, hybrid option with its own characteristics, some better, others worse, than either of the ETF options.

2. Let's say we're going to build a 100 stock portfolio. That's 100 trades to start, so ~$1,000 in brokerage fees at the usual $10/trigger pull. If we want to keep the start-up front end load reasonable, say no more than 1%, then that means a $100,000 ante. That may make sense for high rollers with large lump sums, but it's not feasible for someone with, say, $10k/year of new money to invest. And even with $100k, it's going to take about 10 years for ETF MERs (VCE et al) to offset that 1% FE load.

3. Even with a $100k ante, someone who also has an ongoing flow of new money to add to the portfolio, again say someone with $10k/year, will be incurring additional brokerage fees. Again, let's say minimum $1,000 per ETF and $10/trade, that adds $100/year. So even with that $100k stake, the cost of investing new money fully offsets the ~10bp MER of an ETF.

4. Then there's dividends. If you're retired you could spend them as they come in. Otherwise you've got about $3k/year to reinvest. Even if you use that money to rebalance just the three stocks that are most out of balance, there's another $30 in brokerage fees. It's going to take a lot longer than just 10 years for this scheme to be cheaper than something like VCE.

5. Finally, if we buy your argument about applying global market weights to the total portfolio, then since Canada is only about 3% of world equity capitalization, we'd need at least a $3 million equity portfolio for this to be feasible. We'd also need a comparable amount in bonds to keep (at least my) risk tolerance tolerable.

So apart from those "minor" wrinkles, I'd say go for it. I look forward to reading your next G&M column where you propose this third—dare I suggest the name "Norm's Gambit"?—option ;)
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Re: the ongoing "active" vs "passive" debate

Post by parvus » 28 Apr 2013 17:13

ghariton wrote:I have some sympathy for NormR's approach of throwing darts. Unfortunately my chimp has retired. So I have outsourced to Vanguard's chimp -- or, more accurately, S& P's chimp.
Now it's FTSE's. :wink:

Which goes back to your earlier point: by definition, all investors in aggregate earn the market-cap return, less fees.

But, does the fund capture the market cap? Whose market cap? S&P Dow Jones? FTSE? MSCI? In all probability, this is a scholastic argument, since the differences, at least on large caps will be slight for the average investor.

But then there's investing off-index, for example with a value or small-cap tilt. That can make a difference, to the degree that a) those premia hold and b) the vast majority of investors follow unconstrained market-cap indexes.

Jeremy Siegel once noted that investors were better off buying the 1957 version of the S&P 500 than following it through all its reconstitutions. Of course, the S&P 500 isn't the total market, only around 80% (IIRC). But the stocks were dropped because they became small-cap value stocks -- at least temporarily.
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Re: the ongoing "active" vs "passive" debate

Post by blonde » 28 Apr 2013 17:35

Study the System.

Do not be surprised to learn that IT is Different here, eh?

http://www.youtube.com/watch?v=OI6Ay8Zo-OU
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Re: the ongoing "active" vs "passive" debate

Post by NormR » 28 Apr 2013 17:56

Bylo Selhi wrote:2. Let's say we're going to build a 100 stock portfolio. That's 100 trades to start, so ~$1,000 in brokerage fees at the usual $10/trigger pull.
Or you could go with IB, pay $1/trade, and give Vanguard the finger. I can pick index funds that cost an order of magnitude more that the cheapest ones to make the comparison too. Do you really need such a big leg up? :)

The original study pointed out that you'd do fine sampling the U.S. market with 100 stocks. So, a couple hundred should do fine world wide.

Those who are so inclined could avoid dividend paying stocks to reduce dividend taxes / extra trades. After all, it shouldn't matter because the market is efficient. :wink:

I might also note that a couple hundred bp return advantage can pay for a fair number of cheap trades.

While I don't expect many people to do it, it's an interesting thing to consider.

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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 28 Apr 2013 18:37

NormR wrote:Or you could go with IB, pay $1/trade, and give Vanguard the finger. I can pick index funds that cost an order of magnitude more that the cheapest ones to make the comparison too. Do you really need such a big leg up? :)
Yabbut from what I've read on FWF IB also charges other monthly fees and isn't easy to use. It's a niche service. I'm comparing with mainstream brokers who charge $10/pop.
Those who are so inclined could avoid dividend paying stocks to reduce dividend taxes / extra trades. After all, it shouldn't matter because the market is efficient. :wink:
You're the one who keeps repeating "the market is efficient" mantra, not me. Be careful. Maybe you're starting to believe it's true ;)
I might also note that a couple hundred bp return advantage can pay for a fair number of cheap trades.
Yup. If only such return advantage really exists. I'm still waiting for proof that it does so at least as often as it trails by a similar amount.
While I don't expect many people to do it, it's an interesting thing to consider.
Absolutely. Hence my suggestion to make it the subject of a column.
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Re: the ongoing "active" vs "passive" debate

Post by BRIAN5000 » 28 Apr 2013 19:53

I'll pick door # 3
It's a third, hybrid option with its own characteristics, some better, others worse, than either of the ETF options.
I think two trades a month should handle any re-balancing or additional funds, dividends could either be spent or pseudo drip for free, $240 a year plus time to maintain.

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Re: the ongoing "active" vs "passive" debate

Post by FinEcon » 29 Apr 2013 11:30

Bylo, you can get 50 free trades from Questrade on an any given Monday promo. I would wager it would be fairly easy to get Questrade to promo you 100 free trades with 100k transfer. They slap a time limit on them but for this that doesn't matter. Also the time to expiry is probably negotiable too. Personally, I would go for a trade per 1k transferred in approch if I were looking to implemnent what you an Norm are discussing. Not hassle free because it involves a switch but like George Costanza says, "why pay for something which, if I apply myslef, I can get for free". YMMV
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 18 Jul 2013 17:21

Rick Ferri has a new study:
The success of index investing in individual asset class categories has been widely documented. However, surprisingly little research is available that compares the performance of diversified portfolios of index funds with portfolios of actively managed funds.

<snip>

The outcome of this study favors an all index fund strategy. The probability of outperformance using the simplest index fund portfolio started in the 80th percentile and increased over time. A broader portfolio holding multiple low-cost index funds nudged this number close to the 90th percentile. These results have significant and practical implications for investors seeking a strategy that can give them the highest chance of reaching their investment goals.
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 21 Jul 2013 22:05

Mark Hulbert:
If you think you will know it when this bull market finally comes to an end, you are kidding yourself.

The vast majority of professional advisers who try to get in and out of the stock market at the right time end up doing worse than those who simply buy and hold through bull and bear markets alike. Even those few who beat a buy-and-hold strategy during one period rarely beat it in the next one.

What makes you so confident you can do better?

A surer strategy is to keep a steady allocation through thick and thin. If you are frightened by the prospect of another bear market, then you should reduce your equity holdings now to whatever level you would be comfortable holding through one.
George
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 21 Jul 2013 22:12

\Wall Street Journal
Investors got a wake-up call recently as prices fell on their "safe" assets—bonds.

Whether you hit the sell button or the snooze button reveals a lot about the role you expect bonds to play in your portfolio.

As yields on the 10-year Treasury note began heading up in May, overall flows into bond mutual funds and exchange-traded funds remained positive—meaning investors continued putting more money into bond funds than they took out—according to an analysis by the Investment Company Institute.

But in June, as rates continued climbing and bond returns began turning negative (bond prices fall as yields rise), bond funds started recording net outflows.

Then, faster than you can say Ben Bernanke, Treasurys underwent their biggest price rally in months after the Federal Reserve chairman reassured markets that the Fed's easy-money policies will be in place for the foreseeable future.

So much for buying low and selling high.
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Re: the ongoing "active" vs "passive" debate

Post by ghariton » 21 Jul 2013 22:18

Wall Street Journal:
Mutual funds with performance that ranks among the top quarter—or 25%—of their peers are rarely able to repeat the feat a second time.

As evidence, consider the "Persistence Scorecard" released on Wednesday by S&P Dow Jones Indices. The study looked at 134 large-company U.S. stock funds in the top quarter of performers for the five years that ended in March 2008.

Of those 134 funds, only 16 managed to stay in the top quarter for the five years ended March 2013, says the group, in which Dow Jones, publisher of The Wall Street Journal, owns a minority stake. That is worse than the 34 or so funds that would survive if performance were completely random.

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Re: the ongoing "active" vs "passive" debate

Post by Shakespeare » 09 Aug 2013 10:11

Indexers vs. dividend lovers: How to pick a winner - The Globe and Mail
So what’s the verdict? While indexing wins in theory, it's not by a landslide. In theory, theory and practice are the same. In practice, they are not.

After speaking with many investors, I’m convinced that conviction is a stronger determinant of long-term portfolio success than the choice between indexing and dividend investing. A well-diversified dividend portfolio and a well-diversified couch-potato portfolio are both solid long-term strategies that share several commendable characteristics.

The real risk lies in abandoning either strategy prematurely. Pick one and stick with it.
“A wise man should be prepared to abandon his baggage at any time.” -- R.A. Heinlein, The Door Into Summer.

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Re: the ongoing "active" vs "passive" debate

Post by Bylo Selhi » 09 Aug 2013 10:27

Or consider a hybrid. Use dividend growth in Canada where the TSX is concentrated in a few key industry sectors and where the dividend tax credit provides tax advantages. Then use low-MER broad based market indexes to invest in the rest of the world. Either way(s) I agree that the key is to stick with the program.
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Re: the ongoing "active" vs "passive" debate

Post by Chuck » 09 Aug 2013 16:41

After speaking with many investors, I’m convinced that conviction is a stronger determinant of long-term portfolio success than the choice between indexing and dividend investing. A well-diversified dividend portfolio and a well-diversified couch-potato portfolio are both solid long-term strategies that share several commendable characteristics.

The real risk lies in abandoning either strategy prematurely. Pick one and stick with it.
This is probably true and it may be where dividend investing has an advantage. During a bear market both sides are going to watch their portfolio value shrink. Assuming a year or two recession follows, indexers will watch their portfolios go nowhere, whereas dividend investors will likely see that good old reliable dividend income keep flowing in (possible dividend cuts notwithstanding). Plus there might be a bit of a yield chasing going on which might pump up their dividend stocks price somewhat.

The indexers will probably catch up once the recession passes and the market recovers, but it's during the hard times most people are likely to bail out of the market.

It's all psychological, but divendends may serve as a form of "cold feet" insurance.

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Re: the ongoing "active" vs "passive" debate

Post by tidal » 09 Aug 2013 17:01

I was never a big fan of Ken Fischer (Fisher?) who was (is?) a Forbes columnist / money manager.

But he used to make a similar point. That being forced to go through the extra mental calculus of "Do I really want to sell BCE? BNS? Loblaw?" , etc. - versus, say, "Do I really want to sell XDV?" may be a psychologically handy side-effect / artefact against panic selling.

Don't know.

Robert Shiller also argued in "Irrational Exuberance" and elsewhere that 'story stocks' also contributes to holding-on at overvaluations / bubbles.

Don't know.
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Re: the ongoing "active" vs "passive" debate

Post by Taggart » 09 Aug 2013 17:09

I don't know why the author says "Pick one and stick with it". I do both and they seem to co-exist side by side.

Another point from the article that may cause debate. "But it is worth noting that dividend strategies have a tendency to tilt toward bargain-priced value stocks, and that value stocks have been shown to exhibit both higher risks and higher rewards, which reconciles this apparent disparity.

Perhaps more attune to Ben Graham's Defensive Investor or else closer to Warren Buffett's famous quote that growth and value are joined at the hip.

One thing is, when you're buying dividend growth, you're not buying problem companies (at least not knowingly).

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Re: the ongoing "active" vs "passive" debate

Post by Taggart » 09 Aug 2013 17:21

tidal wrote:I was never a big fan of Ken Fischer (Fisher?) who was (is?) a Forbes columnist / money manager.

But he used to make a similar point. That being forced to go through the extra mental calculus of "Do I really want to sell BCE? BNS? Loblaw?" , etc. - versus, say, "Do I really want to sell XDV?" may be a psychologically handy side-effect / artefact against panic selling.

Don't know.

Robert Shiller also argued in "Irrational Exuberance" and elsewhere that 'story stocks' also contributes to holding-on at overvaluations / bubbles.

Don't know.
Don't forget that Ken Fisher's dad, Phil, was quite willing to hold a good company for many years. Phil Fisher first bought Motorola in 1955. He owned it until his death in 2004.

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