There’s been a lot of buzz around the terms “passive investing” and “indexing” recently, but what exactly do they mean?  In Episode 48, Tom breaks down the two popular terms, and what they actually should be called instead!  You can find the transcript for the video below.  Don’t forget to ‘Subscribe’ to our YouTube channel with EVERY episode of the Mullooly Asset Show by following this link.

Mullooly Asset Show: Episode 48 – “Passive” Investing Transcript

Tom Mullooly: In this episode, we’re going to finally put to bed the whole active versus passive management story.

Welcome to the Mullooly Asset Show. I’m your host, Tom Mullooly, and this is episode number 48. We’re filming this on 7/11 day, so after this I think we’re all going out for slurpees.

Anyway, where do we get these great questions that we discuss, these topics that we cover in the videos? They come from you. So send us your questions. If it’s something that a lot of people are asking, that we’re talking about with clients, we’ll be happy to put it on a video. So keep those cards and letters coming.

Tim, what are we going to be talking about today?

Tim: I’ve been reading a lot about passive investing and indexing. What’s all the buzz about?”

Tom Mullooly: Yeah, what is all the buzz about? Active versus passive. So the whole idea behind passive, is that you buy an index and you just hold the index instead of buying or selling stocks. You know, randomly buying and selling things. I think we need to clear up this misnomer. When I think of passive investing, this is what I imagine in my head. Somebody calls up and says, “I found stock certificates left by my grandfather in the attic of my house. Can I bring them down, they’re 75 years old?”

That’s passive investing, because you bought something, or somebody bought something, years and years ago back in the past, and you forgot about them. You never sold them, and you did probably a lot better than you expect. But passive investing is really becoming twisted today because people are calling, putting money into the S&P 500, into the index, as passive investing. “Well, I’m only going to buy the index.”

Okay, let’s clarify a few things. When you buy the index and when you decide to sell the index, you’re no longer passive, are you? No, you’re active. Let’s drill down to the next level. A passive index, which some people call the S&P 500 to be a passive index, passive index gets rebalanced. The S&P 500 gets rebalanced and reconstituted at least once a year. They’re dropping names off of the S&P 500 and they’re adding other names on.

Same thing happens with most indices, even the Dow Jones makes changes. It doesn’t look anything like what it looked like when I started back in the mid 1980s. So these indices change, people make decisions to buy and sell these indices. They’re all making active decisions. The idea back in the 80s and 90s was to invest with a money manager who had a great track record, and you would buy their mutual fund, or you would invest with them as your money manager, and you would let them do their thing and people thought, “Wow, that’s like active management. They’re beating the market. They’re doing great.”

And then all of these studies come out that say 80% of mutual fund managers can’t beat the market year-in and year-out. Well, let’s just kind of draw the curtain back a little bit and look at this. Most times, these money managers had great track records because they were investing in a style that was working at the time. Maybe it was value. Maybe it was momentum. Maybe they bought companies that raised their dividends. Whatever. The style they were buying made sense.

Now, if you want to buy small cap stocks, you can buy an index that tracks that. If you want to just invest in mid caps, you can buy an index through an ETF that does exactly that. If you want to buy dividend growers, guess what? You can do that too. We can just chuck out the manager that was expensive and now we can just buy the style.

I think there ought to be a pledge on Wall Street to stop calling this passive investing. That’s a made up name, it doesn’t mean anything. Call it style investing, it makes a lot more sense. For instance, did you know that there are two S&P 500 indices? I mean there’s two ways that you can invest in the S&P 500. The Standard and Poor 500 Index that most people are familiar with is a cap weighted index, meaning the largest companies at the top of the list control a huge portion of the activity in the account, and the bottom 450 names don’t really amount to anything. That’s what a cap weighted index will do.

But you can also own the S&P 500 through an equal weighted approach where stocks number one all the way to 500 have the exact same amount in the basket. You know, if you think not just the mega caps are going to do well, if large cap stocks are going to do well, maybe something that you want to take a look at.

Likewise, do we invest in growth versus value? Hmmm. Do we go international versus US? And if we’re going international, do we invest with develop markets? Do we invest with emerging markets? What do you say? That’s why we do the work that we do behind the scenes for our clients to show them what’s working, what’s not working and, which style we want to be invested in.

I think the misnomer there with passive, is that there’s not going to be a lot of active trading going on, but I tend to disagree. It’s a catchy name, it makes people think, “Well we’re just not going to make a lot of changes in the account.” But there’s actually a lot going on underneath the surface.

Great question. Thanks for asking that and if you’ve got questions, get in touch with us and maybe you’ll see it on episode 49.

Thanks for watching.

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