THE PASSIVE/UNDEMONSTRATIVE

Investment Approach

Comfort: a cause or matter of relief or satisfaction; a person or thing that gives consolation; a feeling of relief.

I wanted to discuss a feeling of comfort that came over me this morning as I watched the market decline.  I know markets ebb and flow, but each time you look at your “watch screen” and it starts the day with stocks quotes in total red, it gives you pause, and today, a tendency to flash back to 2008. 

One of the reasons investors are gun-shy is there is still 5 Trillion Dollars missing in the market recovery from the bottom in 2008.  American Households in 2007 had a wealth of 64 Trillion Dollars.  In the meltdown of 2008, they lost 13 Trillion Dollars in assets including house values.  The subsequent rally back up in the market tacked on 8 Trillion Dollars.  There is still 5 Trillion Dollars missing.  One of the reasons is investors sold out at the bottom and missed the subsequent rally back up.  The year 2008 was a bust and the first quarter of 2009 was a bust and any normal investor would have thought 2009 was shaping up to be a bust year too.  Investors had no advice from their advisors on how to avoid the financial killing.  So why would investors believe their advisors if they said the worst was over? 

There is still a big dent in America’s wealth.  Modern Portfolio Theory was the overriding strategy that investors had bought into before the crash and now it was modern portfolio theory advisors wanted them to believe in for the recovery.  Neither passive nor active management approaches did much good in 2008. There is a debate today whether Passive Management or Active Management is the best approach for investors.  Passive suggests you just buy an index, pay a small basis point fee and leave it alone.  The other is to try and find an active manager who can give better than market performance by picking stocks.  The funny thing is the answer lies in combining both methods.  Well, how in the heck do you do that?  “Passive and active together, I don’t get it”?  Ok, think about this. 

There are two Standard & Poors 500 indexes.  Yes, there are two. One is capitalization weighted SPX, (ETF: SPY), this is similar to how Congress is weighted.  In the Congress the states with the largest population have the most Congressmen.  California has more votes in Congress than Rhode Island.  The capitalization weighted S&P 500 gives most of the votes to the biggest stocks like Exxon Mobil. Then there is the Equal Weighted SPXEWI, (ETF: RSP), which gives an equal vote to every stock in the 500.  This is similar to how we weight the Senate.  Each state has two Senators no matter the size of the state.  Here’s the crux of the matter, both indexes trade totally differently.  The same 500 stocks, bundled differently, yield different returns. 

In the last ten years, to date, the SPX, capitalization weighted index is up 22% while the SPXEWI, equal weighted index is up 68%, since both have the same dividends and transaction costs if you purchased them, we left those out and only considered capital appreciation.  Let me ask you this question.  Which S&P 500 index would you have preferred owning for the last 10 years? 

Owning either one would have been considered passive investing.  Just buy and hold.  However active investing would have driven you to purchase the equal weighted index as dictated by our Relative Strength charts when comparing each to the other.  The way DWA is active in our tactical approach is by establishing a “rules based” approach that is identical to what we would have done by hand 25 years ago.  Here’s the interesting part of what we do.  We have taught the computer to manage a portfolio of, say, indexes (passive investment vehicles), and make changes in the portfolio when the “rules based system” suggests changes should be made.  What is missing in this equation of Passive/Active is EMOTION since a computer is operating on our rules.  With emotion missing in the equation we come up with Passive/Undemonstrative or Emotionless investing.  No human being is involved so what you know works is allowed to work.  That one word “emotion” is a typical human characteristic that can wreck havoc on a portfolio.  It was the lack of emotion in our “rules based system” the DWA “Dynamic Asset Level Investing” that kept us out of equities all year in 2008.

So what made me feel so comfortable this morning when I saw nothing but red on my quote screen?  I own our ETF models that are auto-managed.  When a change needs to be made I am alerted on my Cell phone to sell something and buy something in a certain model portfolio at www.dif.pt which has a special DWA Model portfolio system.  I do not have to do anything when a change is made in a model.  Our computer talks to their computer, tells it to sell something and take the proceeds and buy something.  I am simply notified that it happened.  We have the same system in place on a number of Asset Management Platforms.  Professor Levitt of Harvard University once said when you create a product you must create a product that solves a problem.  He said “people don’t want the quarter inch drill; they want the quarter inch hole”.  This is where we are today with investing at DWA, the quarter inch hole, it gives the investor their live back.