Musings on passive vs. active investing
People often ask me about my philosophy on long-term investing. So I decided to write down some thoughts.
At a high level, I believe in a “passive” investing approach that prioritizes:
Tax efficiency – how do we minimize the taxes due within your portfolio?
Low-cost – how do we ensure that you don’t overpay in fund fees?
Simplicity – how do we make things as transparent as possible?
Diversification – how do we provide you with exposure across asset classes, geographies, sectors, and sizes?
To be clear: “passive” does not equate to ignoring investments. Rather, we pick a strategy and we stick with it. Somebody once analogized to me that investing is like a bar of soap: the more you touch it, the more it washes away and erodes your returns.
And, empirically, the data will show this to be true: active management (that is, trying to generate market outperformance through sophisticated analyses, hedges, and technical trades) historically has underperformed any benchmark index – by A LOT.
% of “Active Funds” that beat their passive benchmark over the course of 1yr and 15yrs
You might capture lightning in a bottle one year, but that dramatic outperformance statistically isn’t going to last. As you can see in the data, over 15 years only 4.3% of active managers within the “US Large Blend” category have outperformed a passive index. And, on top of that, when managers are actively trying to beat the market, guess what:
Tax efficiency They tend to be less tax efficient by generating gains and turnover;
Low-cost They charge a premium for this “service”;
Simplicity The investments and strategies are often complex and opaque, and;
Diversification They hone in one very specific nooks and crannies of the market
And that goes against pretty much everything for which I stand…
So rather than trying to chase “alpha” (that is, outperformance), I’m optimizing for consistent, “pretty good” returns that maximize the power of compounding.
But even as a “passive investor” my hands are not completely off the wheel. And there is actually still a decent amount of work that goes on behind the scenes.
1. Periodic Rebalancing. For my clients, each account is built to mimic a “model portfolio”, comprising about 6 low cost, tax-efficient, easy-to-understand, and diverse exchange traded funds (ETFs). Some of these ETFs capture the US market. Others capture international markets. Some capture “mid-size” funds, etc. The point is: we have specific target allocations across sectors, regions, size, etc.
Every time a dividend is paid or cash is added to the portfolio, I use software to re-invest that cash in accordance with our target allocation. If one asset class (e.g. “large growth”) has significantly outperformed, then the weighting of the other class (e.g. “small value”) is, mathematically, below the target allocation and we'll purchase additional “small value” to rebalance the portfolio. These models set clear parameters around reinvestments and enable me to follow the maxim of “buy low [sell high]”.
If we end up selling from this portfolio, we’ll consider 1) the impact on portfolio composition and 2) the impact of capital gains and losses on taxes. Speaking of taxes…
2. Tax Loss Harvesting. This is a big one! Recognizing losses is not necessarily a bad thing in investing, assuming that you reinvest those proceeds immediately. And that’s exactly what I was busy doing in early April when the markets took a nosedive after “Liberation Day”. My preferred ETF provider is Vanguard. But Schwab, State Street, and iShares also have decent low-cost, tax-efficient, transparent funds. What this means is that I’m often rotating between similar offerings from the various ETF providers. In doing so, I can “harvest” the losses (a benefit to clients in that these capital losses rollover indefinitely and offset capital gains) while staying invested in the market in similarly structured products.
3. Identifying Concentration Risk. Sometimes it’s hard to tell if you’re actually well diversified. There are so many funds out there that basically do the same thing but call themselves by a unique name. It’s like ordering a cheeseburger and a hamburger with cheese. Technically, these are two different product offerings. Functionally, they are the exact same thing. If you have individual positions of Nvidia (or Microsoft, Apple, Meta, etc.) – you actually have a lot more exposure to that one particular company (and the tech sector) than you may realize because many diversified ETFs also hold these companies as primary positions! I regularly see folks who have, unintentionally, extremely high concentrations in certain sectors (such as tech). That’s not necessarily a bad thing – but only if it’s intentional and if the risks are fully understood.
4. Reducing Expenses. Fees matter. A LOT. I generally can’t justify funds that have expense ratios of greater than ~0.35%. It doesn’t seem like a big deal until you run the numbers.
A $100,000 investment into ETF generating 8% annualized returns for 30yrs with a 0.06% expense ratio will end up with a portfolio value of: $990,000
Not bad.
A $100,000 investment into ETF generating 8% annualized returns for 30yrs with a 0.60% expense ratio will end up with a portfolio value of: $851,000
54 basis points of fees can dramatically eat away at the ability of the portfolio to compound, lowering the total value by $139,000! You don’t need that.
5. Swapping Mutual Funds for ETFs. The tl;dfr here is that mutual funds are generally not as tax efficient as ETFs. And in times of high volatility (hello, April 2025) they are extremely difficult to tax-loss harvest due to the fact that they only trade at the end of the trading day (vs. intraday with ETFs). Helping folks either convert their mutual funds into ETFs or figure out how to swap out of mutual funds efficiently is often something that I’m pursuing with clients.
6. Communicating State-Tax Free Dividends Proactively. Some investments can have beneficial tax implications in that they are state-tax free or possibly even federal-tax free. But, particularly for US Treasury ETFs, tax software and CPAs alike can’t decipher what proportion of dividends are state-tax free. Rather, ensuring that you reap the state-tax benefits requires a manual adjustment or someone (me) to literally tell the tax preparer that X% of the dividends from this fund are state-tax free exempt. That’s where I can swoop in and provide guidance and insight.
Ok, I think that’s all I got for today. If you’re ever interested in analyzing your investment portfolio to gain clarity and confidence, or just want some thoughts on where I see opportunity/risk/concentration, feel free to reach out.
Best, Josh