A Passive Problem

Low Fees, Please.

If you get your investing lessons from reddit or the bogleheads, or most other internetty places, you’ll quickly learn that passive is better than active, and that you should just index your way to riches.

Now, there’s a lot to be said for the approach of owning a lot of stuff and not paying much in the way of fees to do it. How do you pay the lowest fees? Just take one of everything. That’s indexing.

Are you forgetting something?

Okay. So what to buy? When you learn finance in college they teach you about the concept of a market portfolio. It’s pretty simple, you just own every financial asset in the proportion in which it exists. And here is where we begin to run into problems. M3 money supply is about $14T, and the market cap of the S&P 500 is about $23T. By some estimates, real estate makes up $217T.

So should you have 40% cash and 60% S&P 500 stocks in your portfolio? Or 4% cash, 6% stocks, and 90% real estate? And I haven’t even gotten into corporate, municipal, sovereign debt, non-US equities, etc.. Clearly this is easier said than done.

But that’s just one problem.

We also have another. Even in a fairly well defined area like “non-US equities”, I challenge you to come up with a coherent definition of a passive index that doesn’t require 20 arbitrary decisions to be made via coin flip. How should we weight the index (market cap, by country [GDP? population?]?) Should it include companies HQed in the US who have revenues outside of it? What about countries that have differing ratios of their companies that are publicly traded, should we adjust for that? You get the gist.

So when should passive be used?

Passive investing makes sense as an idea once you’ve carefully defined the space you’re looking in. For large cap US stocks, everybody pretty much knows what we’re talking about. It’s very easy to say “that! there! I want to own that!” And then you buy some of all of it. However, it is a lot more challenging to construct a whole portfolio based on the idea of owning some of everything.

Decide what asset classes you want to own and in what ratios, and then decide whether you can find a passive option that fits what you are looking for.

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