The dangers of passive investing

There is a lot to be said for passive investing.

Key Takeaways from Morningstar’s Active/Passive Barometer Report:

  • Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons.
  • Failure tended to be positively correlated with fees.
  • Fees matter. They are one of the only reliable predictors of success.

Prof. Burton Malkiel, author of A Random Walk Dow Wall Street, writes in the WSJ:

During 2016, two-thirds of active managers of large-capitalization U.S. stocks underperformed the S&P 500 large-capital index. When S&P measured performance over a longer period, the results got worse. More than 90% of active manager underperformed their benchmark indexes of a 15-year period.

…..In 2016 investors pulled $340 billion out of actively managed funds and invested more than $500 billion in index funds. The same trends continued in 2017, and index funds now account for about 35% of total equity fund investments.

Volatility is also near record lows as the market grows less reactive to short-term events.

CBOE Volatility Index (VIX)

Lower fees and lower volatility should both improve investment performance, so what could possibly go wrong?

Investors could stop thinking.

If passive funds are the investment of choice, then new money will unquestioningly flow to these funds. In turn the funds will purchase more of the stocks that make up the index.

Prices of investment-grade stocks that make up the major indices are being driven higher, without consideration as to whether earnings are growing apace.

And the higher index values climb, the more investment flows they will attract. Driving prices even higher in relation to earnings.

More adventurous (some would say foolhardy) investors may even start using leverage to enhance their returns, reasoning that low volatility reduces their risk.

The danger is that this becomes a self-reinforcing cycle, with higher prices attracting more investment. When that happens the market is in trouble. Headed for a blow-off.

Investing in passive funds doesn’t mean you can stop thinking.

Don’t lose sight of earnings.

When prices run ahead of earnings, don’t let your profits blind you to the risks.

And start thinking more about protecting your capital.

Giving Thanks: Ten Reasons ETFs Are Better Than Mutual Funds | ETF Database

For certain investors in certain circumstances, mutual funds make a lot of sense. But while these vehicles can still be useful in a limited number of scenarios, they are bleeding cash because ETFs are in many ways a better solution that can deliver a number of advantages:

  1. Lower Expenses = Higher Returns
  2. Intraday Trading
  3. Enhanced Precision
  4. Additional Firepower
  5. Tax Efficiencies
  6. Transparency
  7. Commission Free Trading
  8. No Minimums
  9. No Redemption Fees
  10. Money Managers On Demand (At A Fraction Of The Price)

via Giving Thanks: Ten Reasons ETFs Are Better Than Mutual Funds | ETF Database.

RAFI ETF Investing: Q&A With Rob Arnott | ETF Database

When you think about capitalization weighting in stocks the drawbacks are fairly evident. When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.

With cap weighting, consider that Australia has three times the GDP of Greece, and Greece has three times the debt burden of Australia. Why should we want to own three times as much in Greek debt as Australian debt? In fact, Australia’s ability to service debt is at least three times that of Greece, and so wouldn’t it make more sense to have an index for bonds that weights countries’ bond debt in accordance with GDP and other measures of the economic footprint of a country?

via RAFI ETF Investing: Q&A With Rob Arnott | ETF Database.

Getting The Most Out Of Your Bond ETFs

Market cap weighting has long been the traditional strategy for not only ETFs, but almost all basket funds. But as the ETF industry expanded, many have realized the benefits of alternative weighting strategies as a number of them outdid their cap-weighted counterparts. More recently these strategies have waded into fixed income territory and yielded several interesting bond ETF products:

  • SPDR Barclays Capital Issuer Scored Corporate Bond ETF (CBND) – This ETF uses three fundamental factors to determine the weight given to each debt it holds: return on assets, interest coverage, and current ratio.
  • Fundamental High Yield Corporate Bond Portfolio (PHB) – This product uses the RAFI approach to selecting its holdings using four factors: book value of assets, gross sales, gross dividends, and cash flow–each based on five-year averages. Note that PHB is classified in the high yield or “junk bond” category.
  • Fundamental Investment Grade Corporate Bond (PFIG) – PFIG also uses the RAFI weighting methodology, but instead applies it to investment grade corporate bonds.

via Getting The Most Out Of Your Bond ETFs.

On High Correlations – Seeking Alpha

If the time horizons of investors are predominantly long, correlations on assets should be low in the short-run, because investors don’t make decisions to trade off of short-term macro factors. But when a large part of the investor base is skittish and is always running to or from the latest bit/byte/bite of data – that leads to high correlations.

ETFs aren’t necessary for high correlations, but they seem to help the process by creating easy ways for people to implement decisions that are a simple idea. “I want financials, I don’t want energy, buy the long bond, sell gold.”

Thus high short-term correlations indicate a momentum mindset in the investor base.

via On High Correlations – Seeking Alpha.