First let me say that I'm biased. I have a practice wherein I offer active management options to clients and do earn a commission for that advice and some of these products. I also both use and offer passive options for clients and have noted the overall rise in passive vehicles over the past few years. I believe there are some concerning issues here though, and felt compelled to explain my concerns. Here they are in no particular order:
A lot of passive mandates are really active: Frankly this is one of my great frustrations when talking to people about passive management. The point of being a passive investor and adhering to that principle is that you don't have a view on the market, and don't make decisions on which sector is going to outperform or underperform or anything remotely similar because you own it all. That goes for country bias and country-specific economies as well. A true passive mandate should be one fund in theory and it should be a total-world mandate. Why are "passive" mandates "advising"(and that’s another topic I'll cover) people to invest certain percentages in certain countries and economies? Isn't the point that you don't make those decisions because theoretically no one can predict which is better than another over the investment horizon? If you could, why would you be splitting up your investment? You would invest it all in the areas that are likely to outperform...and thus just admit that you are managing your money actively to begin with! In Canada we see the "couch potato" strategy gaining more and more momentum and this is the method they put forward. Realistically though an investor who is truly passive should take something like the Vanguard Total World Stock Index for their equity exposure and be done with it. No muss, no fuss and no country specific weightings. In fact, going back to 1964 you see that when Sharpe found that the Global Market Portfolio was the most efficient he wasn't talking about a blend of Canadian and US stocks to a certain percentage or rebalancing every month/year/presidential election. In fact his assertion was simply that there was no more efficient and no other portfolio that would provide a greater return per unit of risk for an investor. According to the people at www.gestaltu.com here is what the Global Market Portfolio would've been comprised of in 2012 (these things are in a state of flux of course):
The Global Market Portfolio, 2012
Source: : Doeswijk, Ronald Q. and Lam, Trevin W. and Swinkels, Laurens, The Global Multi-Asset Market Portfolio 1959-2012 (January 2014). Financial Analysts Journal
Virtually none of the "couch potato" indexers or passive mandates were pressing for an allocation like this however; and frankly as soon as you meaningfully deviate from this you are investing actively. You're making active bets, whether you intend to or not.
The amazing people at www.gestaltu.com offer both the above chart and the below which is a method for the average investor to replicate that Global Market Portfolio:
Upon further examination it becomes clearer that very few if any passive investors (particularly retail passive investors) actually hold the Global Market Portfolio. When you reduce that to its full meaning it becomes evident that there are virtually no truly passive investors and nearly all are active to some degree. Whether they're buying individual securities, a 60-40 balanced mutual fund or collection of ETFs that are said to be passive, the reality is that they are making active bets either knowingly or unknowingly.
The rise of the Robo-Advisor: Automatic asset-allocation seems to be the new fad amongst investors. The idea here is that you can't beat the index, and fees are higher elsewhere so let's pick the cheapest option and settle for the market return minus that fee. These companies have gathered millions and millions of dollars in assets in a relatively short time-frame. Aside from the fact that I have yet to see a purely passive portfolio produced like the one above, there are other concerns. While I would characterize these portfolios as active, despite their pleadings that they are passive, that's not the only issue. If these portfolios really are "set it and forget" then what are the fees for? One provider in Canada provides this service and charges 0.65% for that. What are you actually getting for this? Admittedly they're not providing any advice, and they're not customizing the portfolio for individual investors at all. The entire point is that you invest in a specific allocation and don't change it, so the amount of monitoring and review is obviously minimal if at all. Researchers can't agree on the best time frame to rebalance, and none of the portfolios are truly passive. You're paying for active management, but on the premise that it's passive management.
You get no personalized advice for your situation here at all, just simply a very basic asset allocation model that will underperform the market by the amount of fees charged. When I say the market here, I mean the markets as identified by the ETFs selected in the model; it’s not a true representation of the market as a whole, but a bastardized version. In truth, the providers are making active decisions in one way or another with their model as a basis. They're making active decisions (or made them once) to determine when to rebalance and to what standard. For that, and basically that alone, you pay somewhere between 0.25% and 0.65%. Promoters are keen to advise you that compared to other mandates (mutual funds are often the target) they're much cheaper. That might well be the case, but they're cheaper because you aren't paying someone for tailored advice to your situation. As far as the costs go, I’ve seen one firm charging as much as $3,000 to set these accounts up. Never mind a higher MER, for a guy with $100k that’s a 3% fee plus the MER on the ETFs. Under performance and efficiency is the least of your problems with that kind of fee.
A special shout out to the Couch Potato: In Canada, more than any other, I hear from people about the "Couch Potato" portfolio. It has some great points, there is no question about it. It is cheap, and for someone doing things on their own they could do a lot worse. Full credit to the author for completing FPSC level one certification in financial planning; unfortunately there are many bloggers and online authors who never make it that far. There are a few problems with this strategy though, at least in my opinion. First of all, its not a passive portfolio as demonstrated above. Things are a little stranger here though because not only are you not starting out with the Global Markets Portfolio as identified by Sharpe, but the recommended portfolio has changes as time moves on. Clearly this is an active strategy dressed up to be passive. I also can't refrain from noting that the author is an investment advisor. While I laud him for this and think its both excellent and good, the fact is that there is a fee for this. When you consider that fact along with the active management, what you're really getting here is an asset allocation model which is no more or less relevant than any other active management model on the market.
Let's talk about performance: The promoters of passive management like to talk about the underperformance of mutual funds, but in reality when you buy a passive mandate you are definitely going to underperform the benchmark by definition. So let's say for example that you are paying 0.65% as a fee plus the MER of the actual ETFs that are underlying; you will obviously get that ETF return less the MER and less the fee. It's fine to consider this as a base strategy and be upfront about that point, but a little bit disingenuous to accuse mutual funds in particular of under-performance and then suffer from this fairly obvious issue on your own.
In Conclusion: While the passive mandates have their place and should be considered in portfolio construction, they're not the great panacea that they've been put forward as. There are a number of issues here including what I've reviewed above.