An article I wrote recently attracted an interesting question from a reader about our philosophy on passive investing.

The article, Passive vs. Active: Nothing to fear but fear itself, debunked the idea that the huge and growing popularity of passive investing is making markets less efficient and creating the conditions for a crash.

Reader Ralph Loader wrote to ask about a related issue—our policy of tilting client portfolios in favor of small capitalization and value stocks.

“How, in your thinking, does pure passive investing address different client investment beliefs?” Ralph asked. “For example, like you, I maintain a small-cap, value bias…thus moving away from pure (total market index) passive investing. Can you help me understand how you square that circle?”

I thank Ralph for his question. It goes to the heart of a debate that’s currently raging in the industry over what’s known as factor-based or smart beta investing: Is factor-based or smart beta investing active or passive?

These terms refer to the practice of tilting portfolios toward stocks with certain characteristics or factors. Investors do this because research shows that stocks sharing some common characteristics offer higher expected returns. For example, between 1928 and 2018, U.S. value stocks outperformed growth stocks by 3.3% on a compound annual basis, according to research by Dimensional Fund Advisors. Over the same period, small-capitalization stocks outperformed large cap stocks by 2.16%.

The question that Ralph raises is whether taking advantage of these factors is really active investing in disguise because it moves you away from a “pure” total market approach where you hold every stock in a given market in proportion to its market capitalization.

By tilting portfolios toward value and small-cap stocks, are we trying to actively choose winners in the market? We don’t believe so.

Anytime you choose an index, you’re making an active choice about how you want to capture a given market’s return. For example, when buying the Canadian stock market, you could choose an ETF based on the TSX 60 index, which essentially captures the 60 largest stocks in the Canadian stock market, or the TSX Composite index, which captures about 300 of the largest stocks in Canada. Both capture a large swath of the movements of the Canadian stock market, but they are not exactly the same, despite being “pure” index ETFs.

By using a factor-based approach, we aren’t trying to predict the future. We know that’s a loser’s game that leads to lower returns on average.

Instead, our investment strategy is a rules-based approach that is highly diversified and backed by over 50 years of market data and peer-reviewed academic research. We use Dimensional funds for their expertise in constructing funds that are tilted toward value, small cap and profitability factors based on long-term evidence that these factors produce higher returns.

The debate over factor-based investing may be of academic interest, but the bottom line is that we believe our investing strategy is the best way to capture market returns over the long run, however you choose to define the market. In the end, if the industry decides to label that “active” or “passive” doesn’t really matter.

If you have a question or comment about something I’ve written, or an investment or financial planning topic, please don’t hesitate to contact me at pguay@pwlcapital.com. I’d love to hear from you.