Passive investment funds have stolen ground from active managers in recent years. Trillions of investment dollars now lie in pools designed to mimic major indexes. These pools are tended by mega-asset gatherers charging only a fraction of what active managers charge. In the recent run-up these past five years, passive funds have outperformed all types of active managers.
Passive Investment By the Numbers
Since 2011, passive exchange managers including State Street, BlackRock, Charles Schwab and Invesco equity share prices have made a 23.4% average annual gain, while active equity fund managers T. Rowe Price, Eaton Vance, Franklin Resources, and Legg Mason share prices delivered an average annualized gain of 9.9% over the same span, according to Ned Davis Research of Florida. By contrast, the Standard and Poor’s index gained on average 16.9% annually. Clearly, investors believe that the prospects for passive managers are greater.
Ned Davis Research also reports that active manager growth has been stagnant rising from $2.1 trillion to $2.6 trillion between September 2011, and February 2017. Much of this growth was due to market appreciation. Passive managers grew from $655 billion to $1.6 trillion.
It’s almost as if investors have found their own elixir of success much like the “Nifty-Fifty” stocks back in 1972, a group of growth stocks that history had proven grew in good times and bad. The idea was set it and forget it–don’t worry about overvaluation. Like most fads, that formula ended in disaster.
According to Boston-based DALBAR, the 2017 performance sweepstakes proved extremely close. In that year the Standard and Poor’s 500 Index rose 21.83%, the average passive equity index fund investor made 21.34%.
But what do today’s passive funds provide for those ultra-low fees, and what do investors forego when they buy in? This is a question that should be on the mind of every investor responsible for placing money for themselves or others. In essence, what is the true cost of passive investing?
Passive Funds vs. Active Management
Passive funds use a passive investment strategy aimed at simply matching the returns on an external index like the Russell 2000, or the Standard and Poor’s 500. These pools of securities typically require little or no trading other than rebalancing—when stocks are moved into or out of the index.
Active management involves discretionary securities trading done in anticipation of market turns; active managers follow rules laid down in the prospectus or stated investment philosophy, but they are designed to protect their investors’ capital—ideally putting them ahead of their own interest. The fiduciary duties require managers to put their customers first. They are, in essence, guardians of their customers’ capital.
“One reason for the disparity (of underperformance) is that active managers don’t bet the ranch with your money,” says Boston-based DALBAR’s CEO Lou Harvey. “They hold some aside for the time when things go wrong. This protection takes away from gains, since a portion of your money is held in low-yielding cash and bonds.”
Even worse, investment consultants often press active managers to minimize their cash component, saying that they, the customer, determine how much cash to hold. “That’s like tying one hand of a boxer behind his back. It makes it much harder for the portfolio manager to operate,” says Harvey.
The Growth of Passive Funds, and What That Could Mean for the Future
Passive funds have grown into a major force, according to the Swiss-based Bank of International Settlements. In the United States passive funds amount to about $8 trillion, or 20% of $40 trillion in investment fund assets, as of June 2017.
Lately, most equity money invested in the United States funds has gone into passive strategies following their strong outperformance. For example, passive U.S. funds took in $506 billion in 2016. Active managers endured withdrawals of $341 billion over the same span. Since the financial crisis, active managers have underperformed across most categories.
Some futurists see the trend as permanent, the adoption of “a new technology,” wrote Moody’s Investors Service in 2017 when it predicted that passive investing will overtake active in just four to seven years, as early as 2022. Adoption “will continue irrespective of market environments.”
But other investors see trouble ahead with so much money resting in these pools without a watchman. Charles Brandes, founder and chairman of San Diego-based Brandes Investment Partners, is one of the few voices that have sounded the alarm of a financial bubble brought on by this surge in passive investing. Brandes points to what he sees as an extreme investor obsession over fees, and a single-minded emphasis on short-term results. Both have come to the fore in the latest and longest running bull market.
With bubbles, price dislodges from intrinsic value, says Brandes. Passive management is just that, it does not care about the valuation of any of the companies it invests in but rather each of their weights in whatever index it is trying to mimic. Bubbles are difficult to catch because they can only be realized in retrospect, no matter how frequently the word is used on broadcast television. Witness the dotcom bubble with its eyeballs, soon replaced by pathway to profitability. Or the housing bubble with its fervent belief that house prices could never fall.
One particularly cautionary voice is Ned Davis Research, the Florida-based investment advisory firm made the following prediction last March 2017: “We are in the last phases of a passive index bubble. I think over the next five years there will be great opportunity for active managers to outperform passive managers.” An opportunity for asset managers?
The Costs and Benefits of an Active Manager
The signs of excesses are everywhere. The distortion is different this time around because of its breadth. In the dotcom era all the action was in growth stocks. In 2000, well over 90% of the assets in mutual funds were invested into growth funds. What makes this run-up different is all boats are rising. Passive investing results in the indiscriminate buying of all the stocks, both growth and value. One hint of the overvaluation: The average stock in the S&P rose to 2.5 times in 2017, compared with 1.6 times sales in 2000.
Flows have followed outperformance as passive funds outstripped active funds. Davis notes that passive’s blind, indiscriminate, purchasing can’t help but distort prices in the most liquid cap-weighted index funds like the Standard and Poor’s 500 as they pour new investment dollars into the highest-flying stocks and less into stocks that are underperforming. This self-reinforcing pressure on cap-weighted indexes puts upward pressure on prices. In essence, it buys more of what has gone up and less of companies that have any short-term underperformance. It’s almost the inverse of buying low and selling high.
Brandes sees the indexing movement as being characterized by excessive attention to costs to exclusion of all else—including the discernment brought by well-conducted active managers. This extreme focus on costs has all the bearings of a bubble mania because it focuses too strongly on one factor—in this case, low fees. Is the notion that you get what you pay for not applicable to investing, or has the true cost not been seen yet?
These passive products don’t promise to maximize returns. They promise nothing more than to closely mirror the market index they represent. They offer investors the comfort of conformity. Thus, “the manager who produces market-like returns likely won’t get fired or feel foolish” or look bad before her board of directors or clients. Better to have slightly underperforming index returns “than tolerate occasional periods of significant short-term underperformance from a portfolio with the potential to significantly outperform over a long period.”
The cost of not looking bad is never looking good. And isn’t the willingness to go against conventional thinking the very essence of sustained outperformance?
Active managers charge much more than their passive counterparts because they are trying to do more with investors’ money.
Academic research has helped increase awareness of the futility of the hot-hand argument. Burton Malkiel, Ken French, and Jack Bogle have long supported the idea that hot hands rarely beat the market for any sustained period. Their statistics have been persuasive in convincing the investor that asset managers cannot possibly beat the benchmark. So why then pay an active manager anything?
The reason: Bad as active managers are at hitting the benchmark at present, the individual investors rank worse. And they need the services of an active manager to protect them from themselves; particularly in an investment world filled with shocks and extreme volatility. The investor needs a pilot that can chart a long-term course between the Scylla of fear and the Charybdis of greed for the investors’ benefit.
Proof that individual investors need protection from themselves comes from the DALBAR Quantitative Analysis of Investor Behavior study. Individual investors rarely spend more than four years in any fund or strategy. That means that they don’t stay put long enough to play out any legitimate investment strategy.
DALBAR reports in a special study that over the last ten years the average equity fund investor has earned an annualized return of only 8.31%, as of September 30, 2018. The average actively managed equity fund manager earned 11.02% over the same ten-year span. The difference amounts to 2.71% per year or a 32% difference in return.
And the gap between active manager and investor has become even larger. In recent months aging investors, many closing in on retirement, piled into cash afraid of the market’s dizzying heights and breakneck volatility. Over the last 12 months ending September 30, 2018, the average equity fund investor earned only 11%. But the average actively managed equity fund made 15.19%–that’s a 41% difference. Possible reasons for the sharp difference are today’s apparent ease of converting equity holdings to cash, it’s just a click away. “Before we were having a bumpy road. Now we’re witnessing whiplash,” says DALBAR’s CEO.
Individuals have become ultra-tuned to the trends thanks to broadcast financial journalism. That leaves them vulnerable to stampeding in the service of ratings, like they did when the Ebola scare stories pressed airline stocks like American Airlines down to unprecedented lows, only to see the shares bounce back soon after the panic stopped. How many times since the Financial Crisis have we allegedly been going into a recession or worse?
Investors lose because they move at precisely the wrong time, buying when they should be selling, selling when they should be buying. They let emotions or opinions of others alter their long-term investment strategy. “The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to execute a long-term strategy. In fact, they typically stay invested for just a fraction of the market cycle,” the DALBAR 2017 report says. Essentially the long-term investor is a thing of the past.
When you buy an active manager or an advisor who chooses to be somewhat different than the markets they are trying to outperform, you’re counting on the manager to exercise skills and experience accumulated over years of successful investing. You count on them to do everything they can to protect long-range returns. To an active manager heavily invested in his own venture, losses are not academic.
And most of all you—the investor–are admitting that your financial ship needs a pilot and you are hiring one with the best style that suits your needs. Stop chasing performance. The answer: find the best pilot you can and let them do their job over at least a five-year span if not longer. Focus upon your long-term goals versus short term gyrations and noise.
“What my studies call for is a trusted third party,” says Harvey. “The individual investor is not going to be up on the latest information. The manufacturers of financial products want to gather assets and sell products. Their goals are opposite that of the investor.” Their overarching goal is to maximize assets in their products, the intrinsic values of their individual holdings are of no concern to them.
And even though the federal court has struck down the Department of Labor’s fiduciary rules, active managers and advisors have always had a fiduciary obligation to their clients. The promise: We put the clients’ interest ahead of our own. However, brokers and fund companies still do not have a fiduciary duty.
When you buy an index, you are paying to have your boat floated down the stream without the services of a captain, or even a guardian. In times of crisis you rely on your own resources. We see that this can only bring underperformance as successful investing requires constant attention.
DALBAR shows that individual investors have proven poorly qualified to chart their own course in financial markets; attempting to do a full-time job in their spare time without the necessary experience. By the time investors find out their errors, it is too late.
Where Do We Go From Here?
The rise in passive investment products brings a trend that investors should find disturbing. By seeking out ultra-low fees, manufacturers are turning investors into consumers, and turning a service into a commodity. Index funds are financial products that come with strict explanations of how they work and the many dangers they might face. Those disclosures are there as much to protect the manufacturer, as they are to inform investors. They absolve the manufacturers from responsibility if and when things ultimately go wrong, much like the warnings on a cigarette package.
Look at what’s happening. Every time the market twinges a few specialty ETFs disappear. Never to be heard from again. Where did they go? Recall the recent volatility ETF’s that did not fare well as the market headed south in the Fall.
And now for the coup de grace. Mutual fund giant Fidelity Investments is offering pensioners to manage their money for free. Right. As Wall Street never does anything for ‘free” the question one should ask is how are they making money on this? Fidelity Investments also happens to be selling itself as a fiduciary.
Our advice for investors is to take a long-term view and avoid chasing fads. Chose a long-range benchmark that’s obtainable—like the rate of inflation as this is what truly erodes purchasing power. And choose an advisor whose investment style is one that suits your long-term goals. Pick a style and stick through an entire cycle of five to ten years, remembering that changing your course costs money. Take the time to understand the costs of changing your mind. As chasing current fads, Warren Buffet has said: “You do not know who’s swimming naked until the tide goes out.” The trouble is that by then, it is too late.