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.

Australia & Canada’s experience with equal weighted indices

Correction to my earlier post. Equal-weighted indices don’t always outperform cap-weighted indices, as with the S&P 500. Australia’s ASX 100 Equal Weighted Index underperformed the cap-weighted ASX 100, recording annual growth of 3.79% (EWI) compared to 5.28% for the ASX 100 on a total return basis over the last 10 years.

ASX 100 Equal Weighted Index compared to cap-weighted ASX 100

Canada’s TSX 60 Equal Weighted Index, on the other hand, mimics the S&P 500. Equal Weight achieved an returns of 6.17% over the last 10 years compared to 5.33% for the cap-weighted index.

TSX 60 Equal Weighted Index compared to cap-weighted TSX 60

I will investigate further why Australia bucks the trend but I suspect the banks play a major role. The ASX 300 Banks Index substantially outperforms the broad ASX 300 Index.

ASX 300 Banks Index compared to ASX 300

Active managers and Index funds: How to avoid the pitfalls and get the best of both worlds

From James Kirby at The Australian:

Australia’s big fund managers are now openly bagging index funds and exchange traded funds (ETFs)….Keep away from index funds and ETFs, they cry, the market is too tough for investors to blindly follow an index-style fund when returns are as modest as we have seen in recent times….

But rather than flinging mud back at the active managers…. the passive brigade has instead made two killer moves.

The first move is to reveal quite plainly how the active managers are performing — and they are performing dismally.

The second move is to continually cut prices — or fees — to the point that active managers look very expensive indeed.

Dow Jones’ Indices versus Active Australia Scorecard:

Australian General Equity (Large-Cap) Funds

59.7% underperformed the S&P/ASX 200 Index over one year

69.2% underperformed the benchmark in a five-year period

International Equity General

80.7% underperformed the S&P Developed ex-Australia Large Cap Index in a one-year period

91.9% underperformed the benchmark in a five-year period

I have two major concerns with index funds:

First, index funds reward size, not performance. The bigger a corporation grows, and the bigger its weighting in the index, the more stock an index fund will buy. Over time the index is likely to grow increasingly dominated by a herd of dinosaurs — earning low returns on a large asset pool and unable/unlikely to adapt to change — headed for extinction.

Second, active fund managers perform a valuable role for the entire market, conducting in-depth research of industries, visiting companies and evaluating prospects and performance. Their resulting purchases and sales inform the entire market as to prospective value and under-pin long-term market value. Increasing dominance of passive index funds erodes this capability and will hasten the growth of my first concern.

An easy way to counter the first concern is to invest in equal-weighted index funds. These do not reward size, instead investing an equal amount in each stock in the index instead of weighting by market capitalization.

Apart from eliminating the size bias, the equal-weighted index has another major advantage. It out-performs cap-weighted indices by a sizable margin. The graph below shows the S&P 500 Equal-Weighted Index achieved an annual performance of 8.53% compared to 7.03% for the regular S&P 500 Index, over the last 10 years.

Performance Comparison: S&P 500 (TR) Index v. S&P 500 EWI (TR) Index

The only way to address the second concern is to keep a sizable part of your portfolio with active managers. Don’t blindly follow performance — last year’s winners are often this year’s losers — but follow managers with reasonable fees and proven long-term ability to outperform the index.

The Decline and Fall of Fund Managers | WSJ

Jason Zweig predicts the demise of active fund managers:

So active management won’t disappear entirely. But index funds and comparable exchange-traded portfolios now account for 28% of total fund assets, up from 9% in 2000. And no wonder. Over the past one, three, five and 10 years, only one-fourth to one-third of all stock funds have beaten the index for their category, according to investment researcher Morningstar.

Meanwhile, index funds effectively match the returns of those market benchmarks at fees that often run only one-tenth of those of active funds.

Skeptics have pointed out that if individual investors — those Wrong-Way Corrigans of the financial world — are rushing into passive funds, then active funds might be due for a resurgence….But the net supply of outperformance always is zero; one fund manager can beat the market only at the expense of another who must lag behind it.

Not quite true. Active management is not a zero-sum game. Zweig is ignoring individual investors who, as a body, consistently under-perform the benchmark index.

Mega fund managers are more likely to promote index funds because their size makes it difficult to beat the benchmark index, while smaller, more nimble players are able to do so.

Read more at The Decline and Fall of Fund Managers – MoneyBeat – WSJ.