≡ Menu

Weekend reading: Free PDF on Modern Portfolio Construction

Weekend reading

Good reads from around the Web.

I haven’t agreed with everything written by Cullen Roche of Pragmatic Capitalism over the years – for me he doth protest too much when it comes to dissing passive investors who dare to call themselves that – but I have linked to him plenty of times.

The man undoubtedly knows his investing onions. And even when he sees onions and I see – um – fennel, I usually find his writing a tasty broth worth consuming.

(Mental note: Don’t blog on an empty stomach.)

Cullen has now written a research paper, and it’s basically an investing mini book that you can download for free as a PDF from the SSRN website.

It’s got a serious title – Understanding Modern Portfolio Construction – and it’s a serious read. But not a difficult one.

You say potato, I say passive investor

I think Cullen’s hostility towards the concept of passive investing (as opposed to using index funds and ETFs, which he fully endorses) is made more articulate within the context of this greater work.

He writes:

One of the dominant themes in asset allocation these days is the distinction between “active” and “passive” investing.

While this distinction was once quite clear it has become increasingly muddled in a world in which most asset allocators have become asset pickers using low fee index fund products instead of picking stocks.

After all, a stock picker can be quite “passive” (for example, Warren Buffet has a very low fee and inactive management style), however, the stock picker is not merely trying to capture broad market returns. They are trying to beat the market.

This means that the most useful distinction between “active” and “passive” is as follows:

  • Active Investing – an asset allocation strategy with high relative frictions that attempts to “beat the market” return on a risk adjusted basis.
  • Passive Investing – an asset allocation strategy with low relative frictions that attempts to take the market return on a risk adjusted basis.

This macro thinking highlights the fact that most asset allocators deviate from global cap weighting and are therefore indirectly engaging in an effort to “beat the market” in an active manner.

As Cliff Asness of AQR has noted, one cannot deviate from global market cap weighting and call themselves a “passive” investor.

I’m still not entirely on the same page, but as (some) active fund fees come down and cheaper dealing fees and robo advisers bring down the cost of owning stocks, too, I guess the argument is moving in his direction.

Anyway, download the PDF, have a read and see what you think. (It’s U.S. but relevant – just remember the tax comments don’t tally exactly with the UK).

Have a great weekend, whether you’re active, passive, or just curious… 😉

From the blogs

Making good use of the things that we find…

Passive investing

  • One reason it’s hard to time your way into new bull markets – AWOCS
  • Low volatility will probably deliver lower returns – The Value Perspective
  • Cute tool shows how investing $1 a day did in the US – StockChoker

Active investing

Other articles

Product of the week: The Telegraph notes Santander’s new Help To Buy ISA puts it at the top of the table with Halifax. Both pay a tax-free 4%.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • Swedroe: Momentum delivers, and adds diversification – ETF.com
  • Smart/Strategic Beta is here to stay… – Morningstar
  • …not least because fund managers want to make money – ETF.com
  • Is passive investment actively hurting the US economy? [Who knows, but not persuaded by an article that’s just the latest to misrepresent how market cap weighted indices work]New Yorker

Active investing

  • The latest Investment Trust Dividend Heroes list – This Is Money
  • Is Iran really one of the world’s best investments? [Search result]FT
  • Buffett’s bet Vs hedge funds [Podcast, via Abnormal Returns]NPR

A word from a broker

Other stuff worth reading

  • How ETFs work [Fancy interactive graphics!]Bloomberg
  • Dividend tax changes: Winners and losers [Search result]FT
  • Single, dating, and paying a high price for it [Search result]FT
  • Don’t touch pensions; tax property instead – Guardian
  • Thousands earning less than £35,000 to be deported – Guardian
  • Latest disability benefits cuts seem mean-spirited to me – Guardian
  • Middle class? Your lifetime tax bill could be £3.6m – Telegraph
  • Housel: Read more books, fewer forecasts – Motley Fool (US)
  • Facebook is eating the world – Columbia Journalism Review

Book of the week: Howard Marks’ The Most Important Thing has been made available as an audiobook on CD. This rather retro release gives me a new excuse to plug one of my top five books about investing. Marks is candid about the huge difficulties of trying to beat the market, and he’s an excellent writer. A must read for the sort of should-know-better stockpickers who frequent Monevator.

Like these links? Subscribe to get them every week!

  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []
{ 24 comments… add one }
  • 1 Mike Rawson March 12, 2016, 11:05 am

    If you can’t face the 44 page PDF, I have a summary of the paper on my website:

    Portfolio Construction – Counter-Cyclical Indexing

  • 2 Mr Zombie March 12, 2016, 11:23 am

    I can see Cullen’s point, but it does seem like splitting hairs. Although perhaps fair warning to someone thinking they are a purely passive investor by investing solely in a FTSE100 ETF? Just investing in a broad(ish) ETF does not make a passive investor…right?

    Until there is a truly global ETF or equivalent there will always be some kind of ‘active’ choice involved. Even your split between equity / cash / bonds is active.

    It’s surely a spectrum, rather than just a black or white split between active and passive.

    Right, back to the pdf 🙂 Thanks for the excellent weekend reading, as ever.

    Mr Z

  • 3 John from UK Value Investor March 12, 2016, 12:00 pm

    I’m with Mr Z: Active/passive is a spectrum, and a pretty grey spectrum at that. I like the activity-based definitions, like:

    If you make (or even think about making) asset allocation or stock picking decisions more than once per year then that’s active, while once per year or less would be passive (if I mowed the lawn once a year my wife could reasonably describe me as a fairly passive gardener).

  • 4 Sarah March 12, 2016, 12:55 pm

    Your Howard Marks plug made me do a double take as same name, different bloke is also a drug smuggler who has written books 😉

  • 5 Minikins March 12, 2016, 9:18 pm

    Thanks for the great links. The Cullen paper seems over academicized. And it’s not just because it was, to me at least, a rather boring read, I’m used to reading lots of academic papers. I’m just wondering how robust the concepts really are. I much preferred the Psy-fi read, it was great 🙂

  • 6 Mathmo March 13, 2016, 12:15 am

    Thanks for the round-up this week, TI. I’ve not read Cullen’s soup (skink, surely?) but there’s lots of nourishment in the other links this week.

    I too really enjoyed PsyFi’s post — I’ve been a long time admirer of Kahneman’s thinking, and I recall advice given to me long ago to sit on my hands and not think with them but with my head. Keeping your head when all about are losing theirs is what it’s all about — even when there’s the temptation to catch the bottom of the market. So AWOCS’ reminder that you can’t is most appropriate at the moment in this moment where it feels like the tide is turning. Indeed I’m reminded of our tendancy to look at tops and measure down from them to see what our drawdown / despair looks like, when it’s just as hard to buy at the top as it is the bottom. A quick note that the S&P500 has never been so high when you look at it in sterling.

    Principle & Interest has a fascinating post that gets enjoyably technical fast on the subject of matching liabilities with your asset allocation (the Buffett Will Portfolio, anyone?). I suspect that so often the discussion takes on a governmental approach — kick the can down the road far enough that some other sucker will have to deal with it. If only the accountants and actuaries held such sway over government accounting as they do in the corporate world (such as they do). I wonder whether there’s also a moral angle about the obligation that companies have for their pension obligees — it’s not enough to have self-equity exposure — a broader market exposure would be prudent.

    I also really enjoyed the advice that Stumbling & Mumbling put forth that the young should approach capitalism as a burglar approaches a house. I’ve grown concerned by the recent trend to encourage all and sundry young folk into entrepreneurial pursuits — it’s a terrible choice if others are open to them — at least until they have a better idea of pricing in the real world and a credit history behind them. I’ve occasionally given talks and written about this and my view is that it rarely is the best option.

    Quartix which is discussed in the active investment section, I’ve recently had dealings with — I can attest to how hard it is to end ones ongoing subscription with them, and how unresponsive they are to API / technology requests to use the tracking data more effectively. That may well mean that they aren’t messing around spending unnecessary cash and they do seem to be making money hand over fist as they are one of the easier vehicle tracking services out there.

    Finally good to see Monevator throwing a little comment bait into the mix with the Grauniad suggestion that we should ditch PPR, set off (against the FTs revelations that the dividend changes are good for the rich). In an insane world, PPR is entirely anachronistic and can only be a matter of time before the “mansions” are brought into its scope, even as they are slipped out of IHT. You were hoping for a little politics, right?

  • 7 Gregory March 13, 2016, 9:12 am

    The true passive is the suggestion of Lars Kroijer: the all-world market-capitalisation weighted index.

  • 8 Gregory March 13, 2016, 9:14 am

    Active vs. passive: “It doesn’t matter whether a cat is white or black, as long as it catches mice.” Deng Xiaoping Theor

  • 9 The Investor March 13, 2016, 9:27 am

    Cullen has written a follow-up piece sharing a few more of his thoughts on all this:


  • 10 Mathmo March 13, 2016, 12:09 pm

    Nice response from Cullen. Good for him.

    I’m all for attempts to tighten definitions, but one does need to be guided by the “so-what”. We live in a world where suddenly “passive” is good. No surprise then that everyone who can claim their strategy is “passive” is shouting about it, and those who can’t decry it as a fairy tale.

    Passive isn’t per se good. It’s good because costs matter and because we have no edge. And those things are along a spectrum. A 2-d spectrum.

    On the cost dimension is the strategy cost. Over the life of a portfolio there will be a cost. That will never be zero, but might be very very low. I’d suggest on a human timeline anything under 25bp is all very good. Under 40bp is fairly similar. Above that and over 100bp, things start to add up fast.

    The spectrum of allocation varies from single stock all the way to gfap. The great piece by Authers last year showed that pretty much any sensible asset allocation made of what we consider standard indices with sensible rebalancing gave more or less the same return, which I guess os close to the gfap return (oddly itself not encapsulated in a total return index).

    So back to the two dimensional spectrum, we could choose to plot this on a square if we liked. The bottom left corner is the zero cost gfap. The mythical one true passive portfolio. Stretching away to the right are low-cost, but low tracking options. Single stock buy-and-hold ownership sits at the end. Cheap as chips but with a high risk/return difference from gfap. Up the top are high cost perfect gfap trackers. The closet trackers might live up here. Everything else is scattered on the page.

    If you are “reasonably close” to the bottom left then you might say that you’re passive. If you’re top right you might call yourself active. The other quarters are strange places, but the low cost diy stockpicker in the bottom right often does well for the investor. The lampreys of the top left often do better for the fund manager.

    How do you measure “distance” or decide how far is “too far”. I have my views, but I don’t think they merit explaining here. Suffice to say that nearer is better if you believe that you have no edge.

  • 11 Mathmo March 13, 2016, 12:29 pm

    I drew a picture (I’m sure someone better than me can make this linky or embeddy):-


  • 12 Planting Acorns March 13, 2016, 2:33 pm

    @ Mathmo…. Wow interestingly put. You got the link to Authors ?

  • 13 The Investor March 13, 2016, 3:01 pm

    @mathmo — Love it. I’d happily do a quick post featuring it if ok with you?

  • 14 Minikins March 13, 2016, 3:02 pm

    @Mathmo Ha! Love the graph, especially the scale with “cash under the mattress” at the top and the Slough of Mediocrity as boring middle bit! A fun representation. Interestingly, Ronnie O’Sullivan, legendary snooker champion, has lived his professional and personal life avoiding that sloughy middle ground, I wonder what his investment strategy might be..

  • 15 Gregory March 13, 2016, 6:26 pm

    It is not about active vs. passive debate but it can be part of this weekend list. It is about my mantra: no pain no gain. Value Investing Is Rebounding http://www.barrons.com/articles/move-over-facebook-and-netflix-value-investing-is-rebounding-1457758660

  • 16 Mathmo March 13, 2016, 6:55 pm

    TI – yes of course if useful to wider group, I’d be flattered. Be warned it was only a ten-minute hypothesis and there’s a more rigorous approach available (note particularly “what is distance?”). Even if it takes a mathematician to worry about defining the measure, “further away” and “closer” are fairly intuitive. You have my email address from these comments — drop me a note if you want the original scanned properly, some words, or a redraft. Note also my words and the images have the axes swapped.

    @PA – the Authers article is here:-

    @Minikins – the Ronnie 147 decision was debated on More or Less if you happen to like that show —

  • 17 Planting Acorns March 13, 2016, 7:47 pm

    @Mathmo…hmmm…not as convinced by his conclusions…how clever do you need to be to point out you won’t get anywhere with fees of 2pc plus 😉

    Loved your idea though, and the diagram, thanks

  • 18 elef March 13, 2016, 9:33 pm

    Mathmo the diagram is excellent.

    My thoughts on “distance”:

    The appropriate distance should be the one that suits your investment objectives. It’s slightly more subtle than tactical asset allocation (I like to think of it as a strategic asset allocation). This is because it is anot allocation to try and capture a market return over your whole asset based including assets already deployed. To move from the abstract here are two examples:

    1. An entrepreneur who has 50pc of his money in his oil services business and 50pc in an investment pot. His aim is to have a market return on all his assets at a low investment cost with protection from permanent portfolio loss. For him, investing in say the FTSE100 index would probably not be wise. It is heavily based towards the oil and commodity sectors. Ideally he would look to invest in a tracker fund that displays a negative correlation to the oil price. (I haven’t looked at the raw data but I imagine a bond index of some sort would probably work).

    2. My mum. She draws a solid private pension. She lives in the UK and always will and owns a house she will never move from. Her investment aim is to ensure that she has enough income for the rest of her life, any gains are an additional benefit (I. E. cover UK inflation which erodes her pension income). For her a mix of UK equity and index and non-index linked uk govt bonds fit the bill (it’s a little bit more complicated than that but let’s not get hung up on the details).

    In thone two situations the distance to the global allocation reflects their specific financial and investment circumstances. (I don’t know when cash under the mattress would be appropriate but I’m sure there are some circumstances where it would apply.)

  • 19 The Investor March 14, 2016, 1:02 am

    @Mathmo — Cheers! Will have a think.

  • 20 oldie March 14, 2016, 10:32 am

    from Gregory March 13, 2016 at 9:12 am
    As said, and previous articles on the subject::
    “The true passive is the suggestion of Lars Kroijer: the all-world market-capitalisation weighted index.”

    This makes me wonder is how many of us are passive investors. The issue of “home bias” may prevent many from actually achieving it.

  • 21 Jim McG March 14, 2016, 10:32 am

    The article about fund managers from poor backgrounds performing better reminded me of my mate who went to work for a big city firm as a fund manager. From a Scottish state school and brought up in a council house, he was introduced to a elder partner who quizzed him on his background. It was a pleasant enough chat, and the old buffer signed off with. “Nice to meet you. It’s good that we’re employing more of your sort these days.”

  • 22 The Investor March 14, 2016, 11:12 am

    @Sarah — Yes, that shared name has made me smile a few times too…

    @elef — Well, cash under the mattress is probably best if your dealer is coming to collect in the next five minutes…!

    @oldie — Cullen goes further, if I recall correctly. He says (from memory something like) the All-World market cap index is itself only a partial reflection of global GDP / assets, so even deciding to use that index is itself an active choice (not least because what is in the index is *itself* an active choice… see for example the debates about how much China stock to include in the past year).

    @Jim McG — Hah. Well, yes. But it *is* good. 🙂 I often feel a bit sorry for these unguarded duffers with a heart in these situations (and others such as gender equality). At some point they were probably the progressives, then reality catches up with their sentiments and overtakes them and they can look like they were the problem all along, which might be a bit unfair.

  • 23 Gregory March 14, 2016, 11:57 am

    It is meaningless. Celeb passive/index managers want to mark out from the others so they tinkering. You can make benchmarks endlessly: market cap weighting, GDP/country, GDP/capita. Instead of GDP You can use GNI, etc.

  • 24 Derek @ MoneyAhoy March 17, 2016, 1:02 pm

    I like to think that my investing style is passive in that I don’t try to get more out of the market than should be expected. I do take higher risk than average, but it is still through ETFs (market index funds) and a relatively lower holding in bonds.

    Anyone can pick any random point in time and “outperform” the market. The trick is to do this consistently over the long-term. This is nearly impossible for folks to do without cheating!

Leave a Comment