Wednesday night, I was reading a new paper by some of the principles at AQR titled, ‘Fact, Fiction and Value Investing.’  You can find a copy here and this follows on a paper that they wrote last year called, ‘Fact, Fiction and Momentum Investing (which you can find here).’

Now that you’ve read our primers on value and momentum investing, no further explanation is required, although if you want a refresher, you can click here and here.

I haven’t finished the paper, but already, I like it because they redefine or refine the very squishy terms ‘active’ and ‘passive’ management that form much of the active passive debate.

Traditionally, active managers rely on analytical research, make forecasts and use their own judgement to make decisions about what securities to buy, sell and hold.  Passive manages, on the other hand, have traditionally been described as indexers who simply follow indexes like the S&P 500.

Those definitions are correct, but not completely correct and create confusion for the in-between segment that we pursue.

For example, we own some funds managed by Dimensional Fund Advisors, or DFA.  These funds don’t have active managers that pick stocks based on forecasts or judgement, but they aren’t tracking indexes either.  Some of their funds, like international small cap value, predate commercial indexes.

DFA argues that ‘slavishly’ following indexes is detrimental to returns and that they can increase the expected return of their portfolios by being flexible and making decisions that indexes can’t.  That sounds a little bit like active management, doesn’t it?

I happen to buy DFA’s argument and happen to think that funds that don’t follow indexes but also aren’t active can be terrific solutions for clients.

It’s also appropriate to say that tilts towards value, momentum and size (another primer) are active decisions, since they don’t adhere to the entire, unadjusted market.

This isn’t an original idea, but I’ve thought that the only truly passive portfolio simply holds all the stocks in the world organized by their market capitalization.  Since the US is less than half of the world’s market capitalization, owning anything more than that, a so-called ‘home-bias’, is an active bet like value, momentum, etc.

That’s the case the authors make in Fact, Fiction and Value Investing.  Again, they are not the first to make this argument, but what makes the paper interesting to me is that they distinguish between active bets like the ones that I am describing (value, momentum, size, home bias, etc.) and traditional active management bets based on security selection and market timing.

They refer to this difference as ‘judgmental versus systematic.’  Judgmental is based on judgment: you like the look of a company because of their management or earnings prospects and buy the stock based on that judgment.  This isn’t a criticism, I think Warren Buffet would say that he is a judgmental manager.

A systematic investor, like DFA (and AQR) is active in the sense that they don’t purely hold all of the world’s stocks by their market capitalization (Vanguard has a fund that does) but systematic in the sense that they are very rules or process driven.  They don’t have managers who buy a stock because of management or earnings estimates.

Personally, I’ve been bored by the active passive debate.  It was a little interesting when Gene Fama and Bob Shiller both won the Nobel Prize despite having opposite views on the Efficient Market Hypothesis, but even then, Shiller recommends holding passively managed funds.

I think reframing the question between judgmental and systematic is a much better way to think about it.  We are clearly at the systematic end of the spectrum, although, funnily enough, that also requires some judgment (word games!)