Investors aren't really passive, even when they own index funds. It's a point worth remembering amid the recent dramatic flows into index mutual funds and ETFs.

Consider the hubbub over Burton Malkiel, the man who wrote A Random Walk Down Wall Street in 1973 and inspired the rise of index investing, throwing his weight behind smart beta via Wealthfront's new PassivePlus "advanced indexing" approach. (Malkiel is chief investment officer at the Redwood City, California-based roboadvisor.) James Stewart of the New York Times wonders about Malkiel's "remarkable change of heart," and Crystal Kim at Barron's defends Malkiel by noting that "it's not about active versus passive. It's about fees. It was always about fees."

John Rekenthaler at Morningstar goes a step further, reminding advisors, investors, and mutual fund industry insiders alike that "no investor is fully passive."

Even if an investor buys a single index fund and holds it for nigh forever, they're making an active decision about which part of the world (or which sector of an economy, etc.) they are invested in. An asset allocation choice and not a security selection one, true, but a choice nonetheless, one that could yield better or worse results than the overall investing universe. (Not, as Rekenthaler points out, that you can actually invest in the entire investing universe, though at least one asset manager tries to simulate that.)

And most index fund and ETF investors aren't just buying one fund and holding it. They're buying several of them, perhaps through a target date fund, which means someone (the investor or the PM) is making active asset allocation decisions. On the ETF side, many investors are in model portfolios run by their RIA or broker-dealer's home office or by an outside ETF strategist, models that are often tactical and thus making more frequent asset allocation decisions.

Then there's the matter of security selection inside the index itself. Indexes are created, and regularly managed (i.e. modified) by people, or by algorithms created by people. In the words of Jeffrey Gundlach, "It's just rules-based investing."

"All purportedly 'passive' portfolios — whether asset-allocation funds, ETF managed portfolios, or simply a collection of index funds that an investor has assembled — have incorporated several active decisions," Rekenthaler writes. "If the underlying funds are indexes, based on market capitalization, then the components may fairly be called passive. But the outcome cannot."

So when Malkiel and Wealthfront and others decide on a smart beta approach, they're not switching sides so much as tweaking their approach. 

Edited by: Neil Anderson, Managing Editor


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