Passive investing is not as great as it's made out to be
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If the passive management crowd is to be believed, actual stock picking will soon be an anachronism that belongs alongside age-betraying habits such as hard candy and AOL email accounts. Active funds, their narrative goes, have collectively underperformed the US stock market since 2008, making cheap index investing and “Smart Beta”
the default option for investors seeking exposure anywhere but purely niche markets. What this account conveniently ignores, beyond the fact that actively managed strategies can hardly be categorized in one all-inclusive bucket, is that both index investing and stock picking are generally considered to be highly cyclical. In fact, both investment philosophies have enjoyed multiple and sustained periods of outperformance over the past 30 years.
Passive strategies have historically done best during speculative bull markets or in the final stages of extended bear markets, when there are typically fewer and smaller price movements for active managers to capitalize on. Active strategies, in contrast, perform best when corporate fundamentals are driving returns, especially when bear markets begin or when bull markets resume. It’s worth noting, too, that the latter scenario also favors value over growth for those keen on differentiating between disparate segments within active strategies.
To be sure, though, it’s unrealistic to expect managers to outperform their benchmarks every year, or avoid any periods of underperformance when the underlying investment theses require time to materialize. Active managers would naturally struggle to outperform in a bull market during which S&P 500 has largely trended upwards in a straight line. That being said, truly active managers that can identify idiosyncratic risk have indeed been able to outperform their benchmarks over the past eight years, even on an after-fee basis. But looking holistically across the entire universe of active strategies, as most passive advocates are wont to do, the sheer magnitude of this bull market and the central bank liquidity driving it has conspired against active funds. Cheap debt and big flows of capital into passive vehicles have fed on themselves. It’s a replay of the mid-1990s, when the market shifted to relatively inexpensive exchange traded funds in response to high fees and subpar returns.
Smart beta funds have become so inexpensive and so ubiquitous that there are now more ETFs in this category than there are actively managed large-cap funds. As a result, many stocks are simply being driven by factor or stylistic reasons rather than corporate fundamentals. And a corollary is that many of the more common “smart beta” factors have become such crowded trades that they are almost certainly, distorting the market. To wit, reason would dictate that the most profitable companies would be in demand in a low-growth environment such as today. Ironically, many are trading at near all-time lows relative to the market valuations. The last two times this happened -- between 2000 and 2002 and between 2008 and 2009 – should at least give pause to those investors content to merely ride the index.