How to create the best passive portfolio

The selections of stocks in a quality, dividend or thematic equity ETF depends on the methodology used by the provider and – no surprise – the performance is then shown against the very stocks that have been selected. In other words, there is no evidence that this form of indexing is good at selecting stocks with the required characteristics.

Investors are remarkably forgiving if the index fund does poorly in contrast to an active manager that has to justify what it’s doing and why. Some is fair as the active fund proclaims its ambition to beat the index.

Here the fault lies with the active sector. The recent equity market pattern shows that a value bias cannot match the momentum behind the rally in the Magnificent Seven and their close associates. Persistent proclamations illustrating the huge divide in performance between these stocks and others does not mean the gap has to close. Patterns that favour certain categories of stocks are not predictable.

It becomes even more complex in fixed income where the classic Bloomberg Global Aggregate Bond index perversely weights more into countries that have high debt. Staying at home does not necessarily simplify things. For one, the most common local corporate bond index holds a significant number of credits from international companies that have issued into Australia – it is not a set of domestic corporates as some might assume. The different options on a corporate bond ETF show all manner of different weights and underlying securities.

Most fixed income credit managers hold more than the index to provide options when credit spreads narrow and other sectors present better returns. Yet they are judged against the standard index or even against the RBA cash rate, which has only a passing reference to credit returns.

Reviewing an index

Passive can and likely should be a solid proportion of a portfolio. But it’s not just about picking an index and allocating. A review of what is in the index, the outlook for this sector and the conditions that suit its performance should underpin the weight and expectations.

Thematic ETFs that function like active management are also valid, but are beholden to the way the stocks are selected – largely backward-looking data. Active managers have more insight into the outlook for the stocks, though are also captive to the usual biases. Few active funds will narrow their scope the way that some ETFs do – for example, battery and lithium, or cybersecurity. It goes without saying that the further away from the broadly based index the ETF is, the more its performance will not reflect that index and will more likely be volatile. Surprisingly, some investors irrationally expect these ETFs to do well just because the theme is popular.

Every investment requires a decent level of inspection regardless of whether it is active or passive. The greater the weight, the more the confidence one should have in that investment. Investment conditions do change and both active and passive allocations may need to adapt. Passive is not about being passive – indeed, the word alone could do with a renewal.