Is Passive Investing a Flawed Approach?

Passive investing – which is also categorized as index investing or simply ‘investing in Exchange Traded Funds (ETFs)’ – has gained popularity in recent years within the investment community. In 2015 alone, roughly $150 billion moved out of mutual funds while $150 billion moved into ETFs (according the Thomson Reuters). It is probably a coincidence that the money moving in and out was nearly the same, but that’s not the point anyway. What is clear is that ETFs are gaining popularity while enthusiasm for mutual funds is fading, and this is a trend that has been going on for years.¹

Performance and fees are probably two key drivers of the sea change. Over the last 20+ years, the percentage of active managers (mutual funds and otherwise) that outperform passive indexes can range anywhere from 10% to 80%, but from year to year the actual number fluctuates widely.² If an investor has a manager or managers that have a couple of years underperforming their benchmark (usually an index), the investor might grow tired of paying management fees and decide to take a passive approach instead.

The theory behind taking a passive approach is fairly simple – it offers the investor less in management fees with index-like returns. But does it? There are two little-discussed flaws with the passive approach that can be influential (and detrimental) to performance. 

Flaw #1: Passive Investing that Isn’t Really Passive

If an investor elects to build a portfolio of ETFs—or hires an investment manager to do it for them—it is often labeled a “passive investment strategy.” But this approach sometimes isn’t really passive, and the reason is simple: once an investor starts buying different ETFs and constructs a portfolio with various weightings, the investor essentially becomes an active manager!

In other words, if the investor is tactically choosing what percentages to allocate into various ETFs, it implies that the investor believes there are competitive advantages in certain asset classes (or regions) that can enhance returns. This is certainly possible, and there are plenty of active managers out there that use ETFs successfully. But the point is, it’s not a passive strategy, it’s an active one.

Here’s a hypothetical example. Perhaps you buy an ETF that tracks the S&P 500 because that’s your benchmark, but you also want to own a China ETF and an ETF covering European banks, because you think those areas of the market that could outperform and spruce your total returns a bit. By doing so, you’re making calculated decisions to try and capture those potential excess returns, which requires you to deviate from the chosen benchmark (in this case the S&P 500). You may be correct in your strategic approach, and it may result in you outperforming the S&P 500 for the year. But it’s important to note that your strategy is no longer passive at all, and chances are you’ll end up trading in and out of different ETFs as market conditions change. If you’re going to go this route, it probably makes sense to hire an investment manager that has a proven track record of using ETFs effectively to manage such a strategy.

Flaw #2: A Passive Strategy Won’t Account for Changes to Your Goals

Over time, just about every investor’s needs will evolve. The portfolio objectives may shift from just growth to needing retirement income each year, or a change in health may lead to an adjustment in the investment horizon for the assets. With a passive approach, it’s difficult to adjust your portfolio to account for those life changes. In our view, these situations call for active decisions affecting the asset allocation and portfolio holdings. A financial advisor has the ability to monitor an investor’s ever-changing financial situation and create a customized portfolio that reflects those needs. A passive investor may be limited in their ability to respond to such changes.

Conclusion

There are many active managers that consistently outperform their benchmarks and have long-term track records demonstrating the acumen and ability to do so over time, and some of those managers use ETFs. It isn’t the ETFs that are the problem – it is investors trying to time entry and exit from them, which implies taking an active approach. And if you’re going to actively manage, in our view it makes sense to seek professional guidance.

A passive approach sounds good in theory, but investors must realize that there are a variety of factors (like the ones described above) that really make a passive approach an active one. What’s more, think about what happens with the market declines in 2008. Is it likely that passive investors will hang on to their ETF and just sit back while the market drops? Probably not, which defeats the purpose of being a passive investor in the first place. The key is to find an asset allocation strategy that is poised to help reach your long term investment goals and adjust as your needs change. Making wise choices when it comes to active management is an important component to your plan. At WrapManager, we can help you search. Contact us here or give us a call today at1-800-541-7774 to find out what active managers we’re recommending.

Source:

1. CNBC

2. Forbes