The Hidden Risks of Passive InvestingSubmitted by JMB Financial Managers on January 9th, 2019
It is no secret that investment dollars have been shifting from actively managed investments to passively managed investments. There’s one number that explains a good portion of this phenomena: 7.23%. The compounded annual growth rate (CAGR) of the S&P 500 has been over the last 15 years ending in 2019 has been a paltry 7.23% per year.
This low rate of return has given birth to, among other things, a focus on the costs of investing. It has forced investors to manage costs and expenses to help offset the low returns, and encouraged the use of automation to further reduce expenses wherever possible. In turn, this has given rise to interest passive investing and the birth of exchange-traded funds.
The Transition to Passive Investing
It is also no secret that investors have gone beyond merely shifting a portion of their portfolios to a bevy of low-cost index funds - they have moved millions upon millions of dollars into passive investments and asset allocation models as well.
I believe many of these investors have done so on the basis of cost savings without understanding the long-term implications of their choice, which has the potential for long-term disappointment as a result. For example, a 2018 research study prepared by the Natixis Center for Investor Insight revealed that 64% of those polled believe that index funds are less risky, and 71% think that index funds can help minimize losses.
What You Need to Know About Passive Investing
In reality, index funds have no built-in risk management, and they actually become more and more risky the longer a bull market runs – which is the exact opposite of what investors believe. The most recent example of this would be the run up in the markets from 2000 until 2007 when the financial crisis hit. The S&P 500 Index – and all the index funds that follow the index – grew from 12.3% invested in the financial services industry to 22.5% due to the surge in popularity of these stocks.
Most investors had no idea that nearly one-fourth of their investment was in one industry, and had no idea just how badly the financial crisis was apt to hurt their net worth. The same could be said for the dot.com markets of the late 1990’s.
A Worrisome Trend in Passive Investing
The more worrisome trend, in my view, is the shift to passive asset allocation and other passive investment strategies, and the more powerful effect this has on long-term investment results when compared to individual investment selection.
For example, in a landmark paper published in 1986, “Determinants of Portfolio Performance”, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation is the primary determinant of a portfolio’s return, and in fact it was 90% of the reason for a portfolio’s return. The “Brinson Study” as it is referred to, was revisited by Gary Brinson in 1991 yielded similar results.
A more simplified conclusion from the study is that 90% of the return in an investor’s portfolio will be determined by the mix of stocks, bonds, commodities, currencies, and cash and only 10% will be determined by which specific investments are chosen within each category, and the costs associated with purchasing them.
The returns by asset class in the past 10 years can be seen in the chart below.
(Source: Nasdaq.dorseywright.com; W5000FLT represents the Wilshire 5000 Index; EFA represents the MSCI EAFE Index; DX/Y represents the US Dollar Index; AGG represents the Barclays Aggregate Bond Index; BJAI represents the Bloomberg Commodity Index; investors cannot invest directly in any particular index, and the returns shown are not representative of any specific index funds.) any particular index, and the returns shown are not representative of any specific index funds.)
As you can see, it was far more important to own US Stocks (W5000FLT) and to avoid both Foreign Stocks (EFA) and Commodities (BJAI) than whether you had chosen a particular index fund. Yet, investors with a passive asset allocation strategy not only held a fixed amount of international stocks and commodities for the entire decade, but they bought more of them each quarter when they rebalanced their account, increasing their exposure to losses, and dragging 10 year returns down with them.
Passive Investing is a Non-strategy
Being passive as a strategy is bothersome. It is nothing more than an I-give-up strategy. Oddly enough, it was actually Mao (who was hardly a capitalist) who famously stated, “Our goal is to make our opponent passive”. Therefore, this begs the question of what are investors missing about the index fund as a way to protect and grow their capital?
To begin with, there are thousands of indexes and even more index funds that track them. How do you choose the best one for your situation? If you do all your own research to select an index fund, you have, in essence, become an active manager. Few individual investors have the time, or more importantly, expertise for this.
Markets, by nature, move up and down. Sometimes down comes over 2-3 years, and sometimes it comes in a single, staggering chop. Who steps in to mitigate the damage, and who takes action to re-engage once things have settled down? That would be the individual investor once again.
Finally, there is the issue of the tax ramifications of passive investing. Index funds and passive asset allocation by their very nature cause constant rebalancing. This causes batches of buying and selling, which causes capital gains to be realized and distributed to the index fund shareholder at the end of the year, regardless of the consequences.
Investors need to spend more time understanding their investment strategy, asset allocation and investment selection in order to be prepared for the multiple risks that comes along with it. This will improve the odds of reaching their long-term goals as well as provide a basis for course corrections, as well as stick-to-it-ness when the time arrives.
*Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns and it is an investment strategy that will not guarantee a profit or protect you from loss.
If you lack the time and expertise to actively manage your investments, and are sensitive to the downside of passive investing, then you’re ready for an actively managed account.
Download your copy of A Case for Active Risk Management, to learn how active management can mean the difference between achieving your financial goals and lifestyle dreams by embracing the precision of a well-defined, active strategy.