Beware Passive Investing

Beware Passive Investing
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“Nobody is going to save you but yourself and the best and only way to do so is through action.” – Oli Anderson[1]

Active management is tough business. Alpha-generating strategies can lose their luster in a quarter or two, helping to explain why 80% of active funds underperform each year. The challenges facing active management – particularly the competitive threat of passive products – have never been greater. In response, traditional investment management companies have launched a host of initiatives to fortify their businesses: creating custom portfolios to match unique client requirements, establishing their own index and ETF offerings and revamping marketing/customer relationship services. Less frequently observed are concerted efforts directed at improving fund management skills, processes and ultimately performance (not improvement as an aspirational goal as it is generally approached, but improving deliberately using rigorous feedback and a scientific method).

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Passive Investing

This article takes a hard-nosed look at the pummeling being taken by active management and argues that improving can no longer be approached passively. It must become a core competency for every active manager.

The index tsunami

The global shift in assets away from active to passive products, while already substantial, is about to hit its full stride, according to Moody’s Investor Services. In a recent report[2], they stated: “Passive investments – ETFs and index funds – account for $6 trillion of global assets. Now 28.5% of assets under management (AUM) in the US, their US market share is rapidly expanding, driven by lower cost and better performance relative to actively managed funds.” Moody’s went on to project that within the U.S. passively managed assets will exceed those actively managed sometime between 2021 and 2024. They further estimated that while 5%-15% of assets in Europe and Asia are managed passively today, we should expect this proportion to grow significantly in the near-term.

Moody’s believes this capital reallocation reflects, in large part, investors reassessing their options: “The main driver of flows out of active funds into passive funds has been investors’ growing awareness that, by definition, actively managed investments, in aggregate, cannot deliver above average performance, and that investing is therefore a zero-sum game – for every winner, there must be a loser(s).” An additional driver cited is changing regulations: “Passive investments’ expansion has been further supported by global financial regulation, which has encouraged greater disclosures of fund fees and potential conflicts of interest.” The report added: “In practice, it will become more difficult for advisors to place their clients into higher cost and more complex investment products.” The report concluded: “Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize an advisor’s fiduciary risk.”

Structural shortcomings

Active management is ill-equipped to achieve meaningful improvement due to the heavy dependence upon folklore and poor feedback to support learning. Expressions of folklore routinely include aphorisms such as:

  • it is a good sell as long as the proceeds are reinvested in a winning buy;
  • growth managers are more likely to exhibit the endowment effect; and
  • managers that beat their benchmarks do so primarily by purchasing great names.

Comforting as these and other investment truisms feel they are often wrong, as borne out by Cabot’s analysis of more than $2 trillion of professionally managed assets.[3] Reliance on such pseudo-facts gives individuals a false sense of their own strengths and shortcomings, making it near-impossible to improve.

Poor feedback is what inhibits self-awareness and improving. What type of feedback specifically?

All of it!

Conventional metrics such as relative return, information ratio, tracking error, alpha, attribution analysis and hit rates are merely scorecards. They provide useful information about past performance yet they say nothing about the manager’s strengths and weaknesses.[4] Most importantly, they cannot guide the manager to the one thing she should do today to become a better investor tomorrow. Improving requires facts not hunches, and needs to be driven by rigorous analytics, not emotionally laden recollections or reliance on comforting narratives.

By Michael A. Ervolini, read the full article here.

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  1. We have to be extremely careful with investments, as that is something through which we are likely to gain maximum rewards. I am fortunate enough that I work with OctaFX, as through their help and support, I can do it all nicely. They have brilliant 50% bonus on deposit which is use able and really gives me massive rewards especially with this been use able too. So, it’s all these factors that makes me feel extremely good and allows to perform well.

  2. so logic tells me as the amount of active investors becomes less, the competition within the market will increase, as only the cream of the crop will effectively be allowed to remain… how does this pan out for the future of value investing, or active investing in general?… it will become progressively harder and harder to beat the market… I’m curious as to what the average turnover for individual securities is within these ever more popular index funds… the changeover may provide the semblance of competition, but a security reaching its true value will effectively depend on whether or not the security is placed within an index fund, if it is already not in one… the week to week, month to month, and even year to year price differences depend not on the underlying company, but rather market sentiment towards the underlying company…

    the end result is that it’s going to be horrendous for American micro/small/mid caps and whatever service/product/innovation they could provide, as funding will not reach the necessary levels… while indexing may be safer for the common, passive investor, it is not good for the progression and rate or progression within industry that we have come to expect in our economy…

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