For many investors the decision to use passive investments (Mutual Funds and Exchange Trade Funds that invest in the exact holdings of a specific index) instead of actively managed investments (invested with the best ideas of a portfolio manager and not weighted similar to an index) can be very difficult. With some of the largest investment firms in the world advocating the benefits of passive investing, it can be nearly impossible to make the correct choice. The benefit of having market exposure through inexpensive Mutual Funds and Exchange Traded Funds (ETFs) is undeniable, but is it the best way for an investor to reach his or her financial goal while minimizing risk? Probably not.
The current environment is probably the least attractive for passive investors in the past ten-years for the following reasons:
The passive investment strategy has become very crowded. The top ten index fund and ETF managers hold $8.3 trillion in passive/index investments (Pensions and Investments The Largest Index Managers: 2014 – September 22, 2014. When has it been profitable to invest like everybody else? Never.
Passive investments can never equal or outperform the market. Even though index funds and ETFs have low operating and transaction fees, it is still enough to insure they can never deliver a return equal to, or greater than, the index they track. For many investors their expectations and financial goals are to exceed market rates of return.
Passive investments can’t make the most obvious adjustments. Oil prices are low, the Federal Reserve has announced that they are pursuing a tightening cycle, and everybody knows the top growth stocks of the last five years won’t be the same as the top growth stocks in the next five years. However, indexes and ETFs can’t adjust to these clear market opportunities and/or pitfalls.
Why are passively managed investments so popular?
The best answer is because they have worked really well for the last seven years. Ever since the stock recovery began after the mortgage led recession, index investing has worked. During this time it wasn’t important to be selective when picking stocks. The recovery benefited almost all stocks and sectors equally as most stocks sprang back from unsustainably low levels. Additionally, index funds and index ETFs have created their own tailwind. As the indexes went up after the recession, more money went into these indexes, which in turn, created more demand for the very stocks in the index.
Passive investing is easy. Active investing is hard. Active investing takes time, requires a high level of stock analysis, and demands that stock choices be decisive and non-emotional. Active investment portfolio manager’s reputations are hanging on every decision. Most firms do not have the skillset to successfully manage active investments. Passive portfolio managers only need expensive software to accurately replicate an index.
Passive investors are not (very) wrong, usually. Meaning – the actual return of the investor will be similar (but lower) to the actual return of the underlying index. The great benefit of passive investing is that the investment is always measured against itself (minus fees). Investors can feel good that they are always in the “ballpark” of the asset class they are replicating. This is true even if the asset class has had an extraordinarily bad performance period.
Why is now the time for actively managed investments?
Risk management. Investors mostly become aware of risk management after it is too late. Investors who practiced good risk management prior to the dot com collapse and the mortgage led financial crisis did not see a change in their investment goals or time left to achieve these goals. The explosion of passive investments has created a bubble that will have seriously negative consequence to investors when it matters most.
Passive investments have become less diversified. Investors are unaware that their diversified portfolio has become more concentrated as a small number of stocks continue to do well. For example Apple, Inc. (symbol: AAPL) is a top holding in the S&P 500 Stock Index, the S&P 1200 Global Stock Index, the Russell 1000 Large Cap Growth Index, the Dow Jones Industrial Stock Index, and the NASDAQ Index.
Investing in “new paradigms,” “no brainers,” and “doing something because everybody else is doing it” always ends badly. New investors to passive investing are choosing what has worked the last ten-years and not what is going to work the next ten years.
Since 2009 the phrase “a rising tide has lifted all boats” has applied to stock market investing. Those days and the abundance of indiscriminate opportunities are gone. Going forward the best performance will accrue to the active investors who can expertly select individual investments with the greatest appreciation potential.
Sector selection is now very important to achieve investment returns. Because interest rates are rising, commodity prices are falling, and global economies are in completely different parts of the economic cycle, it is vitally important that investors and portfolio managers choose the right sectors to invest. When interest rates rise should investors be in the financial sector or the utility sector? When energy prices fall should investors be in oil drilling companies or refiners? When China’s economy slows and Japan lowers interest rates while the United States is raising interest rates, what is the best geographical area to invest?
Although the current environment suggests that active management will outperform passive management over the next 5 to 10 years, there is something worse than a passive strategy. These are funds and strategies that claim to be active managers but in reality they invest exactly like the benchmark they are measured by. These are called “closet benchmarkers.” They are bad because they charge active fees but deliver passive returns.
For investors trying to maximize performance and achieve excess returns, it is very important to seek and active approach to investing. However, market exposure is very important to long-term investors. As such, passive investing is still better than not being invested.