Passive, Action, or Robo-Advisor? You probably heard about these concepts quite often these days, but some of them may not be what you think they are. To understand what they are, and which one is best for you, let’s dig into several facts

Passive Products Are Not As Passive As You Think They Are

Wikipedia defines it as follows:

“Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. Passive management is most common in the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities, and hedge funds.

The most popular method is to mimic the performance of an externally specified index by buying an index fund. …”[1]

Essentially, you are buying the “market” through passive investing. In reality, you never really could buy the market since once you enter the market you become part of the market. Instead, you buy some index product that tracks the market, hopefully closely. For example, in the US, the total market cap of public US companies is around $48.6T, and the S&P 500 index tracks about $38.4T, i.e., around 80% of the market (numbers are as of 9/30/2021).

Besides, index providers change the universe of an index from time to time. This could be due to some stocks getting delisted from the exchange, or some of their characteristics no longer fit the criteria of the index, for instance, their market value might become smaller enough to be replaced by other well-performing stocks. In another word, passive products by no means are static.

Active Investing: It’s Likely Already Embedded In Your Investment Process

On the other hand, active investing requires active management of the investment strategy. Oftentimes, active investment products take an index as a benchmark and try to beat it(with some risk target or return target). The process includes but is not limited to strategy development, risk management, rebalancing, etc. Active investing takes time and expertise, and hence active investment products are typically more expensive than passive ones.

From a retail investor’s point of view, if you consider yourself a real DIY investor, you are probably doing active investing already as you are seeking to make personalized investment decisions. Often, people confuse passive investing with investing in passive products. Your investing could be active even if you only invest in passive products. For example, Target Date Funds in the US have been gaining steam since 2006.

“In the US, the use of Target Date Funds accelerated from 2006 onwards with the introduction of automatic-enrollment pensions legislation, where the convenience of a single ‘fund for life’ made them the most popular type of default strategy. Since that, time TDF assets under management have grown more than 10x reaching $763 billion at the end of 2015. …”[2]

Target Date Funds(TDF) consist of a series of vintage mutual funds that normally become less risky as a plan participant gets closer to retirement. The concept of TDF itself has some active elements in it, as it typically is based on some glide path model that optimizes the objective utility of plan participants, which leads to the derisking shape of the glide path. Further, each vintage fund of the TDF is likely based on asset allocation model(often based on Modern Portfolio Theory), which requires the fund managers to come up with assumptions on the products in the fund, such as return, volatility, and correlation estimates of them. Once the funds are designed, they also ought to be periodically rebalanced to target allocations, perhaps monthly or quarterly. In this sense, TDF management certainly shares some aspects of active investing.

Or consider a simple 80-20 portfolio, i.e., a portfolio containing 80% equity and 20% bond assets. Why 80% equity, why not 100% the “market” portfolio? Or why choose SPY or VTI as the equity portion, why not include international stocks? All these require some degree of active investing decisions, and whether investors realize it or not it’s probably a good idea to at least think about it and even better maybe rationalize these decisions.

Factor Investing: The Lines Between Passive and Active Investing Are Blurred In Some Areas

With the advancing of technology, some investments that used to be active are now considered passive by some. Factor investing, which takes certain aspects of stocks, and adjusts their weight in an index by ranking these aspects, has been adopted by many investors, including some major index fund providers [3], thanks to the efficient process due to computer automation.

Robo-Advisor: A Hybrid?

Speaking of computer automation, a new kind of investing style, Robo-Advisor, emerged in 2008 and has been gaining momentum since [4]. According to the descriptions of some Robo-Advisor services, these investments often invest in index funds with investing algorithms developed in-house. These algorithms typically first evaluate the risk tolerance of an investor and select a set of portfolios based on an investor’s investing goal and risk score. Sometimes the algorithms even go as far as reducing the risk exposure of investors’ portfolios during market stress, such as when the equity market has a significant downturn.

Considered a hybrid by many, the market of Robo-Advisor is projected to continue to grow organically for the years to come [5]. As a retail investor, it is important to understand to what extent the algorithm makes active investing decisions before considering using them. After all, every active investment comes with its own active risk, which if not managed properly could lead to undesired investment performance.

Total AUM($MM) of Robo-Advisors

Which One Is Best For You? 7 Points To Consider

At least the following aspects need to be considered when it comes to deciding which investing style to choose.

• Cost: Normally active investing costs the most, followed by Robo-Advisors, and passive investing
• Flexibility: The more active it is, the more flexibility it could give you, so by going passive you essentially take whatever is given to you.
• Performance: Many people say passive investing beats active investing in the long term. However, I believe every person has one’s own investing goal and horizon, and one investing style doesn’t always outperform others over that particular horizon
• Tax: This is perhaps the part that Robo-Advisor delivers good value. Some Robo-Advisors utilize automated Tax-Loss-Harvesting algorithm to take advantage of the Tax credit from underperforming trades
• Time: Engaging in active investing takes time and effort to do proper research
• Expertise: If you don’t have enough knowledge and don’t plan to educate yourself about investment, then perhaps going passive, or seeking an advisor(could either be a human advisor or a Robo-advisor) would be a good choice
• Resources: Researching active investing involves data collection and analysis, perhaps engaging in discussion with others as well, it could be challenging if these are not available to you
• What’s your opinion? Leave the comments below.

Reference

[1] https://en.wikipedia.org/wiki/Passive_management
[2] https://en.wikipedia.org/wiki/Target_date_fund
[3] https://investor.vanguard.com/etf/factor-funds
[4] https://www.investors.com/etfs-and-funds/etfs/fund-industry-wakens-from-slumber-to-take-on-digital-advice-upstarts/
[5] https://www.statista.com/outlook/dmo/fintech/digital-investment/robo-advisors/worldwide?currency=usd#assets-under-management