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.

CEO pay is rigged | Barry Ritholz

From Barry Ritholz:

CEO pay is rigged.

If that sounds more like a late-night presidential tweet than a fact, let’s consider the evidence.

The compensation packages of the chief executive officers of America have been rising faster than just about any rational metric upon which they are supposedly based. “CEO pay grew an astounding 943% over the past 37 years,” according to a recent Economic Policy Institute analysis. EPI further observes this was a far faster growth rate than “the cost of living, the productivity of the economy, and the stock market.”

CEO compensation isn’t the pay for performance its advocates claim. Instead, it is unmoored from any rational basis.

We may blame corporate boards for allowing this abuse to happen, a breach of their duty of stewardship, but why isn’t more being done about it?

Those in the best position to press for changes in executive pay are the giant fund companies like BlackRock Inc. and Vanguard Group Inc….. Vanguard Chairman and CEO Bill McNabb said in an interview last fall that rather than only rely on proxy votes, the firm has been pressuring companies behind the scenes to pare back outrageous packages. That approach makes sense, given that the indexing giant, for the most part, can’t simply sell the stock of uncooperative companies without uncoupling their funds from the indexes they are trying to track.

It looks like passive investing is part of the problem. Membership of an index ensures that a stock will be supported by passive, index investors. Plus boards can use stock buy-backs to support their own stock price, giving them partial control over the major performance metric on which they are rewarded.

Only active fund managers will dig deeper and rate management on their ability to create long-term value. Unfortunately their influence over stock prices is shrinking.

Source: Excessive CEO Pay for Dumb Luck – Bloomberg View

Smart and Stupid Arguments for Active Management | The Reformed Broker

Are active or passive investment strategies best? Josh Brown at The Reformed Broker writes there are both smart and stupid arguments to be made for active management:

Marketocracy’s Ken Kam, who has spent a career studying and vetting active managers, touches on one of each type in an interview with Covestor the other day.

First, his smart argument, the thing about all strategies that is always true:

“My experience has taught me two important lessons. One, there is no sector or investment style that works all the time. And two: a great manager gets that way by honing his skill in a single sector or style. The combination of these two lessons is that if you want good performance over time, you can’t get it by using the same managers year after year.

My approach is to look among the managers who have proven themselves over the long term to find those whose style is performing well now. If there are a lot of proven managers who are all performing well now, then I choose managers whose styles are different from one another, to reduce the impact of any single manager’s style falling out of favor.”

This is absolutely correct, there is no strategy – be it active, passive, value, growth, long-short, arbitrage, mean reversion, trend-following, stock picking etc – that will always work in all environments. Kam gets this correct. The trouble is, most passive guys say they don’t care about this or that style being out of favor, they will wait ’til the cycle swings back around – “Forget the needle, buy the haystack” Jack Bogle exhorts us. Most active guys, on the other hand, will be the last to recognize (or admit) that their expertise is not beneficial in a particular market moment.

Kam’s other argument is of the “stupid” variety. Please understand that this is a very smart man making it, so no insult intended:

“Owning an index fund is like being a passenger on a jet on automatic pilot. Today’s automatic pilots are so good that one might argue that having a human pilot on board is an unnecessary expense. But would you be willing to fly on jet without a human pilot on board? Perhaps if the sky is clear you might consider it. But certainly not if you thought you might be flying into a storm.

I think index funds make sense for those who see clear skies ahead for the stock market. For those who see a storm coming, having a human pilot at the helm makes a lot more sense.”

Okay, I’m gonna stop you right there.

The passive investor absolutely does not see “clear skies ahead” at all times. Rather, this investor recognizes that most managers will not be able to detect and react to the thunderclouds in a timely, consistent way. In addition, many of them will be so hyperactive that every gray cloud will appear to be a hurricane, and so a lot of buying and selling (churn) will be the result – leading to higher taxes, trading costs and potential for missed opportunities.

While Josh does not take sides, professing that he is ambivalent about whether active or passive management is preferable, he says in the past five years passive has outperformed active investing.

I agree with Kam and Brown that no investment style works all the time. But I disagree that index funds out-perform in a bull market, when there are “clear skies ahead”. Active investors using momentum or trend-following strategies will comfortably out-perform the index. But, as Brown points out, most active investors fail to react to an approaching “thunderstorm” and will get caught in the ensuing bear market. Holding fast-moving stocks, they then under-perform the index, with sharp falls and severe capital draw-downs. And in the uncertainty that follows, like 2010 to 2012, active investors will also under-perform: with no strong trend there are too many false starts.

My conclusion is that active strategies out-perform in a bull market, while passive strategies are more resilient when there is no strong trend. Neither do well in a bear market, but passive strategies incur relatively less damage. Using technical indicators to identify the start and end of bull markets may seem the obvious solution, but can lead to false signals and expensive “churn”. A thorough understanding of macroeconomic indicators is essential to confirm market signals, but this can take years of study and is not for the faint-hearted. At all costs, do not try to make forecasts; even professional economists seldom get this right. Simply use the indicators to identify market risk and adjust your strategy accordingly.

Read more at Smart and Stupid Arguments for Active Management | Joshua M. Brown, The Reformed Broker