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Active Vs Passive Investing: Set, But Don’t Forget

Hands On or Hands Off

Active Vs Passive Investing: Set, But Don’t Forget

Much like pulling for a sports team, in investing there are those who root for the passive approach and those who vote for active. The number one line that the ‘passives’ preach when giving an argument against active approaches is that passive investing is much cheaper.

After all, so they say, why pay a manager to buy the index who will generate solely beta (market return)? The active camp would then reply saying, well what happens when the market goes down, and one is only invested in a simple S&P 500 ETF?

What the Majority Likes

The data over the past few years does show that passive funds have been receiving a good amount of inflows, so on the surface at least, one could conclude that this is what the majority prefers, at least at the current time. But although passive funds are great in some scenarios, they are by no means perfect.

Assuming the investor buys a standard index fund where the underlying asset tracks the movement of the top 500 US firms, as those companies are weighted by market capitalization, when the stock goes up, even if the number of shares outstanding remains constant, the market will rise. What drives an index is, therefore, price movements.

But here’s the catch. For a value investor, would one not want to invest in companies which have been beat up and also from a growth investor’s point of view too, would they not want the smaller growth companies that have room to shoot up and give you some bigger bang for your buck? If the answer is yes, the simple passive fund is not for you.

Putting Some Numbers on It

Assuming both assets, that is the MSCI world index on both market cap and equally weighted measures are rebased at 100, what one finds is that the standard measure has underperformed the equally weighted version by around 125 points from 1999-2014. What this means is that the large companies have not delivered on their hype, or past performances.

So while the big super tanker pension funds invest in passive index funds, what they are really doing is reducing the average person’s retirement income year after year, on a relative basis. Take the firm Vodafone that has a big weighting in the UK’s FTSE 100. If one compared the performance of Vodafone versus the MSCI world index during the first six months of 2014 while rebasing both at 100 (not equally weighted – if it was, the spread would be even greater), Vodafone falls to around 70 while the index touches circa 103. In the US, Google suffers a similar fate against the MSCI world index.

The big beasts of the index simply do not perform as well. But that is not news – of course, they wont because they have less scope to grow their businesses and generate large-scale returns.

The solution is either to go into index funds that do invest in growth companies if that is the strategy or just personally manage an active portfolio. That way, one gets the benefit of generating alpha (if they’re any good) and avoids the huge pitfalls of passive investing.

The Future of Passive

When the market rises, typically volatility is suppressed because no one is a seller. Over the past few years, the VIX has been eerily low as a result of the Fed and many other central banks buying assets. This actually creates a self-fulfilling scenario for passive investing because when volatility is low, a simple market index will suffice. As more people believe this, more and more capital gets sucked into the passive arena, creating even less volatility.

The VIX currently sits at just over 11 and will likely go even lower for a couple of reasons. Firstly, the US fundamentals do look favorable irrespective of some whopping growth plan from the White House. Secondly, the equity put call ratio, that is sentiment of investor positioning, is sitting at 0.61. A figure < 1 shows the market is positioned for a move higher, while > 1 shows bears taking over. As the market tracks higher, passives will experience greater inflows.

Conclusion

On the flipside, because volatility is so low, position sizes for the active manager can and should be increased to generate even higher returns. But one should remember hat crowded trades are the most hazardous assets to be invested in.

When the paradigm changes and although it may not materialize for a few quarters, when it does, the fall will be deep. When that time comes, the passive approach will have very few takers.

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