Passive Investing is Communist Nonsense

If everyone invested in passive funds the markets would be destroyed

It’s hard to imagine a topic that can trigger bar fights within the typically stuffy financial adviser industry yet the Active vs Passive debate is unironically it.


What’s It All About?

It boils down to this… When you invest your money do you want a human manager to look after your money or do you want to use a robot?

Active (Human) Investing is when you hire a fund manager to manage your money for you. You pick a fund manager (or a bunch of them) and hope that they can spot good investment opportunities for you. The overall aim of a fund manager is to make more money than the markets do.

Passive (Robot) Investing is when you copy a market index1 (FTSE 100, S&P 500 etc) and leave your investment to it. As you are mirroring the market you can’t beat it, you just roll with it and hope the markets continue to go up (which 80% of the time they do).


What Do Active Investors Say?

Active investors aim to outperform the market by picking and choosing stocks they want to hold. This relies on the investment managers ability to spot trends and to buy stocks that will deliver high returns and avoid ones that are likely to lose money. It’s a lot of work and active funds are more expensive than passives because of it. Investors will also need to monitor the performance of their investment managers to make sure they are continuing to deliver. If a manager underperforms the market then this can lead to investors moving their money elsewhere.


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What Do Passive Investors Say?

Passive investors aim to match the performance of their chosen market rather than outperform it. Passive investors know that outperforming the market is hard and being able to outperform the market over and over again is harder still. Passive investors know that most active investors underperform the market and only a small portion consistently outperform. Passive investors can’t be arsed to monitor the performance of the anyone managing their money and would prefer to accept a return in line with the markets instead of risking a below market return while they chase higher performance.


Why Does Everyone Get So Riled Up About It?

From an investor perspective there is no clear answer on which is better. Sometimes Active beats Passive, sometimes Passive pummels Active. Generally speaking Passive’s deliver higher returns during rising markets while Active’s delivers better returns when markets are on the decline. As markets rise 80% of the time that would seem to indicate that Passives are a better bet.


If Passive’s Are OK, Why Have We Given This Article A Snarky Anti Passive Title?

There is potentially a problem at the market level. In 2016 Sanford C Bernstein & Co published a report titled: “The Silent Road to Serfdom: Why Passive Investment is worse than Marxism”, a fantastically tittilating title for a report that was widely covered at the time. The report argues that in a market ruled by passive investing, capital is not efficiently allocated to the most productive uses.

Vincent Deluard (Prof of finance at Saint Mary's College and CFA Society) wrote:

The passive sector is creating the reality it was designed to mirror: the tail’s wagging the dog. As passive share of the market grows, prices are set by the interaction of the passive sector’s mechanistic rules and trading algorithms.

Deluard points to 6 symptoms of passive investing:

  • Valuations structurally higher and rising

  • Corrections are rare and shorter

  • Large stocks outperform

  • Prices are disconnected from fundamentals

  • Returns disconnected from economic indicators

  • Soaring executive compensation

All of the above is happening right now but that could be because of the money printers trying to stimulate the economy and debasing the currency at the same time.

One thing we must also consider is that as a nation prints currency past the value of its resources you get into the field of creating inflation and damaging the economy. It’s a slippery slope… we will watch this play out over the next 25 years.

So what can we do? Lucky for us Deluard has provided some answers:

  1. Go with the flow. The passive bubble hasnt ended yet and there is still time to profit from it.

  2. Exploit passive distortions. If a company gets included on an index, passive funds will be forced to buy it. This is a powerful trading opportunity (imagine if a memestock like Gamestop made it onto the list!!)

  3. Buy unpopular companies (energy/tobacco) that provide a great yield but are shunned by ethical and growth orientated funds.

Interesting stuff.

Until Next Time

The Wealth Gap


1

A Market Index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. An index can be made up of anything. For example a FTSE 100 index would be made up of the 100 biggest companies in the UK while the S&P 500 index is made up of the 500 biggest American companies. There are thousands of indexes to look at and selecting an index to compare your fund against can make all the difference on how good your fund looks in comparison.