I think the active – passive discussion is moot. It is largely ideological with few useful results for the investor. There are two ways to think about the problem, that illustrate that.

Passive investing is simply buying and holding an index ETF, you say? But which index or combination of indices is the market? You will have to actively decide what to passively follow in the first place.

Let´s say you choose the S&P 500, buy SPY and be a passive investor. Well, the S&P 500 index is not a passive entity – it even has an investment committee, that selects the index components. The committee doesn’t even have to follow purely systematic rules – they have discretionary leeway much like a fund manager!

What´s more, the S&P, because it weights companies by market cap, in effect uses a trend- following methodology – it overweights the best performing components.

Considering this, doesn’t it make sense to think hard, if you really want to follow these particular active ingredients?

Thinking about the problem from the opposite angle provides some very helpful insights as to how to build and adjust a portfolio.

I have described in different articles, that in general my strategies aim to harvest well known and documented sources of return, that are driven by risk premia and advantages exploiting investor´s consistent behavioral inefficiencies – sources of return that could be called beta and alternative beta.

Alpha is what the active manager adds to these well known sources of market beta. When alpha becomes well known and widely used it deteriorates and becomes part of market beta.

An edge for the investor lies in combining available beta sources in an intelligent way. A thorough understanding of why different sources of return persist and how these returns are likely to be distributed and correlated to each other, is the key to be able to build a superior portfolio.

My argument is that such an investor is not actually actively beating the market. He is simply generating superior risk- adjusted returns by combining available passive return streams and balancing them, using systematic ways that capture known behavioral inefficiencies. Indices like the S&P 500, asset allocations like the 60 / 40 portfolio or others can be thought of as underperforming over the long term, because they do not utilize all the return streams and behavioral inefficiencies the market provides – they are just a part of the overall market. I view off-the-radar risk premia like the volatility risk premium or systematic sources of returns like factors or trend as part of the mix that the market provides (termed alternative beta, because these return streams are not as widely used as the equity risk premium, for example).

Considering the investing reality of the average „passive“ buy and hold investor, holding a static allocation of index funds, reveals another practical flaw of passive investing: While it is easily possible to devise a solid static portfolio, an actual real- life passive investor seems to be a very rare breed.

Buy and hold in practice translates to an average holding time of about 4 years for the average equity fund investor. Performance chasing leads investors to increased buying at market tops, combined with panic selling at bottoms. This leads to a behavioral performance gap for individual investors of around 4% underperformance compared to holding the index as the long- term Dalbar study shows – that means the returns that the investor takes home, are only about half the returns the fund realized.

Financial planning is largely based on average return expectations, ignoring the vast fluctuations around the mean, which make the actual realization of the average return in any given year a rare event. The challenge with averages is, that they can be highly unreliable and investors know this deep in their gut. If lacking good systematic tools to protect them from extreme changes in the market, behavioral biases lead them to change their allocation anyway, rather than continue holding, as they emotionally react to market conditions at exactly the wrong time. Loss aversion, one of the strongest forces in investor behavior, will lead to increased risk aversion in bad times – investors going to cash exactly when expected future returns increase. Fear of missing out in strong markets will cause them to jump on the train, while largely disregarding risk, when expected returns are particularly poor. Many investors have still not fully recovered from the 2008-09 bear market because they raised cash in 2008 when things got really bad and did not get back into the market for a long time, if at all.

The solution is to take that into account and adapt our portfolio systematically, against our instincts. Actively changing asset allocation to address changing market conditions is the best practical method in the real world.