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Active vs. Passive Investing

November 30, 2016

 

Much has been said about getting rid of money managers: replace them with robots, algorithms and any other black box you can think of. You can save some money on fees and in the end according to the stats, very few managers, if any, can consistently beat market indices, especially when they are going up.

 

Funds that represented indices and then Exchange Traded Funds (ETFs) were the first step in this move to a passive investment process. These funds are designed to replicate the different global market indices as well as the underlying industries they represent. Why bother learning anything about an oil company? If you want to own oils, then just buy an oil Exchange Traded Fund and you will own every oil company that trades in the market. This also applies if you just want to own any one industry or country. If you do not like an industry or country you can even bet against them as there are now ETF’s that go short (sell stock they do not have) as well. And the fees are a lot lower, as they should be, as nobody is really making an investment decision of any type – all stocks in this world are equal whether the company is a good one or a bad one. Just own all of them and hope that the majority are going to be good enough to pull the other ones along.

 

One of the problems with investing this way, is that it basically wipes out the reason for having capital markets in the first place – which is to allocate capital in an economy to those companies that need it the most – usually when they are starting out or they are trying to grow their business to compete in the world. Take this function away and ultimately you do not have public companies. Any new business formation will be minimal and the wealth of corporate ownership will be concentrated on the very few. Just imagine if everyone who went to the bank to get a mortgage was given the same approvals irrespective of their credit worthiness. No bank would remain solvent for long. Likewise, the impact on capital markets and society of passive investing is a problem, as new capital needs to go to those companies that create jobs and wealth for a nation.

 

Active fund management and equity research has the function of fostering higher growth rates in the overall economy through the promotion of more efficient capital allocation. Only those companies with good business models have access to capital as there is a required expected return based on the prevailing interest rate. This can only be determined via a diligent research process.

 

Ultimately more efficient capital allocation provides the optimal diversification of resources and improved risk sharing, that results in more integrated and better functioning capital markets that serve the economy by contributing to growth and jobs.

 

One reason for the growth in passive is “short term-ism” – investors have lost patience and want instant returns that are better than anybody else’s – returns now usually get measured every quarter and even every month. However, trying to achieve returns on a monthly or quarterly basis is not investing. It is speculating. An investment requires a commitment to a business and its management throughout a business cycle. Otherwise company managers start running their business to maximize profits for the short term rather than investing in the business for the long term and eventually they end up out of business. This might well be the reason why so many businesses have been caught so off guard by new secular trends and are struggling to survive today.

 

Some argue that all the money will never go 100% under passive management, so why worry? Unfortunately, it does not need to.  The impact on capital markets liquidity is already being felt now as passive management has proven to magnify correlation shocks, to the detriment of real investors who want to own businesses and not just electronic recordings of corporations that are valued on the latest price.

 

The role of passive investing does have its benefits in that it lowers cost of access to equity market exposure for the average individual and brings down the overall cost for government pension funds.  However, even in ETF investing there is someone making the decision as to what industry and which country to invest in and how much – so asset allocation, which is perhaps the single most important function in investing, is still an active decision that has to be made and should be different for everyone depending on their risk tolerance and time horizon.

 

Once Artificial Intelligence (AI) is introduced in money management things could change even more dramatically towards passive investing. Today a lot of people already advertise this, but few actually have it outside of Google or IBM. But even AI cannot forecast those unpredictable black swan events of which we are seeing more each day.

 

When is passive investing most effective? When markets are going straight up. As an investor you then participate in this rise at the most optimal cost. But if markets are going down, you do not want to be in a passive structure that forces you to lose money, no matter how low the fee. There are also long periods when the markets go sideways with strong volatility in between where passive can be detrimental to one’s returns. In fact, unless one can forecast uninterrupted periods of rising markets, it can be quite problematic to go passive.

 

In the end, even the smartest of computers, with all the Artificial Intelligence in the world will not be able to forecast those one-off events (wars, terrorist attacks, natural disasters, political upheaval) that could cause liquidity to leave the markets en mass and see portfolios fall precipitously.

 

The role of a good money manager is all about dealing with human psychology and ensuring you do not sell at the wrong time (the bottom of a market like in 2009) or pour all your money into the market when everything is so overvalued that you have no hope for a positive return for ten years (the U.S. market in 2000 comes to mind).

 

The average investor is not well educated on how the economy works and how markets price events in, and this role could well be taken over by either a human or a machine. However, when it comes to handling human psychology, which requires “hand holding” during outlier events, a human being as an investment manager still has some value even in the land of Artificial Intelligence.

 

It is not a coincidence that “do it yourself investors” on average make a lot less money than the average professionally managed fund as it is these buy and sell decisions during unforeseen events, whether of stocks or passive funds, that erode performance.

 

In the end, those with the best long term returns are paying fees to have someone call/email them during those difficult times where greed or fear could rule the day and cause endless losses. So more important than whether you should have an active or passive investment strategy, is the question of whether you have the right portfolio manager/financial adviser who is available for you to talk to pretty much 24/7 should circumstances require this.

 

The Summerhill Team

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