Does Overweighting Domestic Stocks Count as Active Management?

A reader writes in, asking:

“I’ve read in the past that you utilize Vanguard’s LifeStrategy funds.  You and I share the same passion toward favoring passive strategies rather than active. My question is then, do you consider the funds’ home bias reflective of an active strategy that deviates its asset allocation away from traditional weightings (based on actual market cap) inconsistent with Vanguard’s overall approach to indexing?”

I don’t have any strong opinion on whether the domestic tilt of the LifeStrategy portfolio (i.e., the fact that the LifeStrategy funds overweight domestic stocks and underweight international stocks relative to their market capitalization) constitutes active management.* If, however, it does count as active management, then there are several other characteristics of the LifeStrategy (and Target Retirement) funds that we must also consider active management. Specifically:

• The overall stock/bond breakdown does not reflect the respective sizes of those markets,
• Non-investment-grade bonds, bonds with maturities of less than 1 year, muni bonds, and TIPS are generally excluded from the portfolio (because none of those bonds are included in the Vanguard Total Bond Market Index Fund), and
• The portfolio is rebalanced rather than simply allowing the allocation to each piece to shift naturally in accordance with market capitalizations.

If we’re treating one of those decisions with skepticism — because it could be considered active management — then we must be skeptical of each of the others as well.

Personally, I don’t worry too much about whether something is or isn’t active management. The primary problem with the most popular forms of active management (e.g., paying a fund manager to pick stocks or time the market) is that they increase costs without increasing returns by a sufficient amount to overcome those additional costs.

But the LifeStrategy (and Target Retirement) funds’ policy of overweighting domestic stocks doesn’t actually increase costs. In fact, it reduces costs slightly because the domestic index funds have somewhat lower expense ratios than the international ones. In other words, the skepticism with which I generally regard active management strategies (because they, in general, don’t improve returns enough to overcome the additional costs) doesn’t really apply in this case (even if it could be considered active management).

*With regard to whether the fund is somewhat out of character for Vanguard in particular, I can only say that Vanguard is pretty consistent in their message that they aren’t an indexing-only company and they have no philosophical opposition to active management.