Is Passive Investing a No-Brainer?

Passive - Active signpost drawn on a blackboardPassive Investing 101

The tsunami of money flowing out of actively managed mutual funds and into passively managed funds continues. It seems everyone has finally realized the simple facts: active money managers struggle to beat their benchmark, and passively managed money carries much lower fees.

But before you throw all of your money into an S&P 500 index ETF or something similar, please understand that the benefits of passive-over-active may not be quite that simple.

Active versus Passive Investing

Part of the active-versus-passive debate is in the semantics. Usually when people use these two terms, they are referring to passive money management as a ‘rules’ or ‘index based’ methodology to determine which stocks to buy or sell. If you invest in an S&P 500 index fund, the fund will buy everything in the index and seek to replicate the performance and makeup as closely as possible.

In other words, there is no manager at the fund who is making discretionary buy or sell decisions based on their own research, which is classically called active management. Active managers seek to use their skill to actually beat a market index over time.

Fees and Performance

What goes hand-in-hand with this distinction is that active managers usually charge a higher fee, given the research and resources they are employing. The average annual fee for an actively managed mutual fund is 0.77% (and it can be much higher), versus 0.10% for passively managed funds.

Combine this with the fact that only 20% or less of actively managed funds beat their benchmark over various time horizons, and you can see the appeal of passive: lower cost and better performance!

I won’t argue with lower costs – it is about time that actively managed money firms face some competition and encounter pressure on their high fees, especially for mediocre performance.

But this isn’t the entire equation. First, the whole active-versus-passive debate is a bit of a misnomer. Any kind of investment undertaking is an active decision, and if you are investing in an index fund, most indexes are constructed on a market-weighted basis.

This means you are buying more stock in larger companies rather than in smaller ones. It may be a rule and a non-discretionary way of managing money, but it is still an active bet on larger companies versus smaller ones.

Further, managers may be labeled as active because they are trying to beat a benchmark, but that doesn’t mean they could still use a rules-based methodology in their investment process, similar to an index.

Finally, while costs are traditionally higher for active and lower for passive, this doesn’t necessarily have to be true, and it may now be undergoing some changes.

The Downside of Passive

Robo-advisors have become increasingly popular, amassing a large amount of assets under management as many people flock to efficient and low-cost portfolio management using passive ETFs. This in itself is a great thing, and something that many people should consider, especially if they are just starting out in their career and have a long time to invest until retirement.

However, while the past eight years of the bull market have made passive investing seem like an obvious choice, the question will be whether investors can stick with it through the next bear market.

Bear Market Blues

The best thing about passive investing is that it tracks an index closely, but in a bear market this could be the worst thing because there is no built-in risk management. For example, if your entire portfolio is invested in a broad stock market index, such as the S&P 500, then when the market goes up 200%, you won’t lag the market by much. But when the market goes down, perhaps by 40% to 60% – which is not out of the question for stocks – you will also go down by the same amount!

This may seem obvious, and investors are hopefully well aware of these warnings. There is also much literature available that shows that even with these massive drawdowns, if you just buy-and-hold, you will continue to see steady gains, averaged out over time.  

Morningstar and Dalbar

Unfortunately, while investors think they know this in theory, their behavior indicates otherwise. Each year, Morningstar computes the actual investor return versus the fund return, and they have found that investors give up over 1% per year over 10 years due to pulling money out of funds when a fund goes down and putting it back in at the top once a fund has gone up.

Dalbar’s research reveals even worse results, with investors only getting about half (or even less) of the performance of the stock market! Investor psychology is the primary driver of this underperformance, as humans continue to buy high and sell low.

What Can an Investor Do?PassiveIncome

Let me be clear, there is nothing wrong with passive investing, and I believe most investors should use it as one of their core portfolio components. But in order for it to work, you need to be aware of the risk and be prepared not only to buy, but to actually hold. Sticking to the process is what makes it work.

Investors also need to know themselves well enough to realize that if they can’t handle a certain drop in the value of their portfolio, then they need to give up some future performance for the added peace and ability to withstand the pressure in the future.

This should come primarily from diversifying away from stocks and bonds and into cash and tangible assets such as gold and silver. Then when the next bear market comes, your portfolio will be much less volatile, and you will be much more likely to stick to the “hold” part of the equation!

Market Rallies Don’t Always Make Sense

Market Rally FollyStimulate Economy - Red Button

Can government infrastructure spending, or “fiscal stimulus,” create more wealth? The stock market certainly seems to think so. As financial publications have recently opined, the stock market has been hitting record highs (Dow 20,000!), at least partly because investors believe the new Administration will usher in an era of government spending on things like roads, bridges, telecommunications and defense. While this may give some companies a boost, it will be a drag on long-term economic growth.

The Seen Versus the Unseen

The art of economic thinking is always to consider the seen versus the unseen. In the case of infrastructure spending, what is seen is the widening of highways, the new suspension bridges and the faster internet cables being buried underground. It is easy to see how this spending could be a good thing because the wider highways and faster internet probably enhance productivity.

Furthermore, any government spending – even on bridges to nowhere – is seen as beneficial, due to the Keynesian idea of the “multiplier effect.” This theory posits that governmental spending gives the construction workers more income, who then go and spend the income on other goods and services such as restaurants or new cars.

This in turn gives those restaurant staff and car manufacturers more income, which they then promptly spend. Each dollar the government spends is therefore “multiplied” throughout the economy.  

The Unseen Hand

What is missing from this analysis is the unseen. For government to spend any money, it must first get that money from somewhere; taxes are the most direct method and borrowing is another option, but this only means higher taxes in the future to pay for the borrowing.

While the government technically can’t print money directly to finance spending, it can do so through other means, which cause inflation and which are – you guessed it – just another form of tax.

Therefore, since taxes can only be taken from those who are creating wealth (for example taxes on profits or income), or from the existing base of wealth (such as real estate taxes), then by definition, government spending can only be accomplished through the transfer of wealth.

But Isn’t Infrastructure Useful?

Proponents of government spending may agree there is a transfer of wealth occurring, but that wealth is being employed into productive uses, such as infrastructure. After all, the construction and maintenance of roads allows businesses to ship their goods all over the country more easily.

It is true that things like roads, bridges and electrical grids are useful. But the pertinent question is how useful? If money is taxed away from a business to build a road, that business may no longer be able to build another manufacturing plant and provide an increasing number of products at a lower price, employing more workers in the process.

In other words, infrastructure spending faces a calculation problem. While politicians can hazard a guess that a wider highway or a public transportation project has some value, it is impossible to know (or prove) that the project is more valuable than what the private sector would have spent those tax dollars on.

If this calculation problem were enough to give cause for concern, there is also a problem of incentives. Infrastructure projects that are likely to be funded are those that will create the most jobs or please the most constituents, not the ones that make the most economic sense.

This logic means that the Keynesian “multiplier effect” does not exist, because every dollar spent to begin with does not come out of thin air but must instead be redirected from something productive. In fact, some of the latest rigorous academic research has confirmed the government spending multiplier to be negative, not positive (see a nice summary of this research from Dr. Lacy Hunt of Hoisington Management).

Employee IncentiveWhat this Means for the Stock Market

The stock market is always forward-looking, and it is likely making new highs for a host of reasons on which financial journalists can only speculate. It is also true that increased fiscal spending could give select companies a lot of extra business in the short term.

However, valuation levels for broad market indices such as the S&P 500 are currently at some of the highest levels in history, exceeded only during the dot-com bubble and the brief run-up before the Great Depression. At current levels, the stock market would have to decline by anywhere from 40% to 60% just to return to historical norms!

To be clear, valuation tools are not timing indicators, and anything is possible in the short term, including a continued bull market in the months ahead. However, what valuation models of the stock market can reveal is that, over the longer-term (10-12 years), investors should expect very low returns (low single digits annually) if they invest at these elevated levels.

Diversify across All Asset Classes

The best strategy is to stick with a plan of being diversified across asset classes, including hard assets such as precious metals, other commodities and real estate.

And don’t let any infrastructure spending plans fool you into thinking it will be a huge boost for the economy and the stock market!

2017 War on Cash

US dollars and troops2017 War on Cash

Overshadowed by colossal events such as Brexit, the U.S. election and the Dow nudging 20,000, investors may not have noticed an escalating war over the past year: the sinister War on Cash.

We have previously covered the ongoing “currency wars” of central banks that continually try to depreciate their currencies with lower interest rates and quantitative easing. But this goes even further because it is a war on actual, physical, paper cash.

Unprecedented Strikes Against Cash

2016 saw prominent academics and politicians shamelessly writing about the benefits of reducing or even outlawing cash. Former Secretary of the Treasury, Lawrence Summers, called for the U.S. to get rid of the $100 bill.

Former Chief Economist for the IMF and Harvard Professor, Ken Rogoff, published a book entitled The Curse of Cash, followed by numerous op-eds and endorsements by the New York Times and Financial Times endorsing a ban on cash. Australia is currently reviewing whether it will ban its $100 note.

India’s Prime Minister, Narenda Modi, announced without warning on November 8 that all 500 and 1,000 rupee notes would cease to be legal tender. Although claiming these were “high-denomination” notes, they actually equate to approximately US$7.50 and US$15 respectively, and they constitute 86% of the country’s cash currently in circulation!

Banning Cash: Rationale versus Reality

One of the biggest reasons cited for banning cash is to cut down on crime. While it is true that criminals prefer cash for the anonymity and the ease of transactions, there is no reason to believe enterprising criminals will stop their activity because transaction costs will be higher.

Criminals will easily substitute other forms of payment: lower denomination bills, other valuables like silver or gold bullion, diamonds, bitcoin, etc. Even Tide detergent has been found used as a common currency for drug trades.

The popular press surmised Tide was used by drug users because it could be stolen easily and traded for a quick fix. Yet this misses the point of why drug dealers would accept Tide as a currency at all.

The reason Tide became a currency was because it fit most of the properties of what makes a currency viable. It is recognizable (given the brand name), homogenous, easily divisible, and it has a (relatively) high value-to-weight ratio, making it portable. Bottom line: criminals are enterprising enough to surmount all kinds of obstacles inherent in illicit trade, so banning cash will not turn them into law-abiding citizens.

The next reason for banning cash is a little closer to the truth; to curb black and grey market transactions and collect all of the taxes the government is currently missing out on. India’s actions are squarely aimed at this because most Indians make virtually all daily business transactions in cash.

Further, the government will be receiving a report on any Indian citizen who deposits more than 250,000 rupees as a result of trying to rid themselves of the now illegal notes. The intention will then be to assess a tax and penalty on any of this money, if viewed by the government as unreported income.

While this may give a little boost to government coffers in the short-run, it is likely to backfire because the overall effect will be to tamp down economic activity in general, leading to even less wealth creation and less tax revenue.

The Real Reason for a Ban on Cash

The biggest reason for banning cash, especially in developed countries, is for governments to have the ability to enact even more extreme negative interest rates. Rogoff and others are actually quite transparent about this, recognizing that if banks charge an ever larger negative interest rate on deposits, savers have the option of withdrawing their money in cash and stuffing it under a mattress or in a vault, costing them less in relative terms than paying the bank to hold their money.

This highlights the ludicrous position in which central banks have put themselves, yet it is obviously the next logical step in their fallacious reasoning. To a central banker, if zero interest rates have not sufficiently spurred an economic boost with increased borrowing and spending, then the next step is to make interest rates negative, something we are already witnessing on a smaller scale.

But if minimally negative interest rates do not work, then their logic is to remove the next barrier to make interest rates even more negative. Thus the wrong intervention of the first action necessitates further interventions that distort the regular function of banks and interest rates even more.

Savers and Investors

The biggest surprise of the recent currency bans and proposals to ban currency in developed countries has been the lack of protest from citizens. Most people already use credit and debit cards for many transactions anyway and don’t seem to see the problem.Many coin bank of yellow and white metal. Cash closeup.

However, if negative interest rates are imposed on regular bank accounts, and savers have no way to withdraw their money, they will likely become more a lot more interested in what is really going on here. Fortunately, many alternatives exist to regular currency, and while governments may try to curb an exodus to these alternatives, it will likely be hard for them to do so, given the myriad of substitutes available.

For example, gold and silver will remain popular substitutes, as well as other alternative assets like other commodities and real estate; perhaps Tide detergent will even become more widespread as a common currency! Technology will also enable the ownership of these assets to be transferred and verified more readily.

In any case, investors and savers need to stay properly diversified and remain informed…..

Time For Holiday Rebalancing

Ho Ho Ho or Ho-Hum?

Stock market investors are looking to have a rollicking Christmas this year, while holders of bonds and precious metals may feel like they are getting a lump of coal. Yet taking a closer look at what has developed in the markets since the U.S. Presidential election reveals that not all may be merry and bright. In short, it is time for rebalancing your portfolio.Work life balance concept

What’s driving the stock market

Since November 8, the S&P 500 is up nearly 6%, while the Dow has catapulted 8% and is looking to break 20,000 by year’s end, leading many to call this the Trump Rally.

The first thing to keep in mind is that the stock market typically rallies in an election year, and most new Presidents enjoy a “honeymoon rally” after the election, as chief economist David Rosenberg has noted. Markets hate uncertainty, so a close election that didn’t end in a tie and drag on for months gave the stock market a sigh of relief as the ambiguity ended.

Second, also as Rosenberg has ably pointed out, the S&P is largely being driven by two sectors the market perceives to benefit from the new administration: energy and financials. These two sectors are only 20% of the S&P 500 but they have accounted for nearly all of the gains; the other sectors have remained virtually flat.

Take a step back

There is nothing inherently wrong with this because sectors do go in and out of favor; but it is telling that this is not a broad-based rally. It also adds more political risk because market participants believe these sectors will benefit from deregulation. This probably could not happen due to the political games played in Washington, but even if it does occur, it will take a very long time to work through the political process.

Finally, the S&P 500 is now at the third most expensive valuation level ever, exceeded only by the dot-com bubble and a very brief point right before the Great Depression (as measured by the CAPE ratio). This is not a timing device or even a prediction that markets are set to crash, but it does mean that over the next 10 to 12 years, investors should expect low single-digit annual returns or worse on average.

The Fed is not the cause of bond yields rising

Many have attributed the spike in bond yields and interest rates to the anticipation, and the subsequent action, of the Federal Reserve raising interest rates. This is only partly true.

Remember that the Fed can only set interest rate targets on the rate that banks lend to one another. This certainly influences the attitudes of other bond buyers, but it is a relatively small market. And with the Fed out of the QE game for now, they are not directly intervening in the larger bond market.

What is a much larger force in the bond market is China, which has been furiously dumping U.S. Treasury Bonds. China has gotten rid of so many U.S. bonds that they have now given the title of largest holder of U.S. debt to Japan!

China is likely doing this to try to prop up their falling currency, the yuan, as they battle a credit crisis of their own. Although it hasn’t received a lot of mainstream press, things are getting so bad that China briefly suspended the bond futures market, and has been injecting emergency loans into the banking system.

China’s woes are an article for another day, but the bottom line is – watch out for China!

Low-priced gold and silver – exactly what you want right now

Gold and silver bugs are probably feeling more like the Grinch this season as they have watched gold tumble 11% and silver almost 13% since November 8. Yet this is exactly what you should expect and want.

Remember the purpose of precious metals in a portfolio; not to produce lots of juicy returns or return on capital, but to preserve capital. Indeed, year-to-date, gold is still up 7%.

So if precious metals are expected to hold value or even appreciate in times of inflation or when stocks fall, then they should conversely be expected to fall in times of dollar strength and stock market rallies.

This negative correlation to stocks is exactly what makes gold and silver so valuable and important as a stabilizer and insurance policy in a portfolio. It is also why we consistently recommend a 10% to 15% Hand writing the text: Where to Invest?allocation.

Rebalance your portfolio now

The slump in precious metals combined with the sharp rally in stocks at the end of the year signifies the perfect time for most individual investors to rebalance their portfolios.

Rebalancing to your target weightings automatically allocates money away from expensive assets (like stocks) to assets that are likely undervalued such as gold and silver. So this holiday, take cheer in knowing you can take some money off the table and sleep soundly at night with a well-balanced portfolio that is primed and ready for whatever 2017 may bring….

Production Spurs The Economy, Not Consumption

Economy

Economy

With Black Friday and Cyber Monday now behind us, economists and investors are hoping people shopped till they dropped in order to give the economy an extra boost. In addition, the latest GDP report on Tuesday came in higher than expected, largely driven by consumer spending. However, buying more flat screen TV’s  isn’t what makes an economy healthy.

Many people believe the fate of the economy relies on retail sales and consumer spending, especially because news outlets continually note that “the consumer sector accounts for two-thirds of the economy.” Unfortunately, this is not only misleading but it is also mistaken economic theory.

What GDP Is – And Is Not

The measure of GDP, or gross domestic product, is simply the value of all goods and services sold within a country. While this seems like a simple enough calculation, the devil diddles in the details.

One problem is that the calculation only accounts for the sale of final goods and services. This is done in an attempt to avoid double counting. For example, if a steel maker produces steel that is then sold to an automaker to build a car, only the final sale of the car will be counted and not the earlier sale of the steel. This is one reason why GDP data is so dependent on consumer spending.

This leads many to believe that consumer demand and spending is what drives an economy forward. This is a notably Keynesian idea where recessions are caused by drops in demand and cautiousness causes consumers to keep their wallets closed. Following this line of thinking, the solution to any stagnant economic growth becomes obvious: get people spending!

True, there is a grain of truth here because the money I spend on a new sofa goes into the hands of the shopkeeper who then has income to spend. In the same manner, if nobody buys my services, I will not have any money to buy that new sofa. The gears of the economy would grind to a halt without spending.

Putting The Cart Before The Horse

Spending money does move the economy, but only to the extent that it is an exchange of goods and services. The critical step everyone seems to forget is that in order to spend money, you must have that money in the first place!

How do you get that money? By producing something of value that someone else wants. Therefore, it is production that drives the economy, not consumption. There is never a problem or a drop in consumer demand because people never tire of wanting new and better things; the problem is maximizing production to fulfill more of those wants and needs.

How is production increased? By increasing productivity. How is productivity increased? By saving, or deferring consumption so new tools can be forged and research undertaken to increase productivity.

A Robinson Crusoe Economy

Imagine you and your friends are stranded on a deserted island, and it takes all day to catch that one fish or harvest those few coconuts that you need just stay alive. Your economy is 100% consumption, correct?

How could you improve your standard of living? Not by consuming more, but by actually consuming less. You and your friends would need to go hungry for a day or two and use your new-found spare time to construct a fishing net, fashion a spear, or create other tools to make procuring food easier.  

This would in turn make you more productive, allowing you to gather more food during the course of a day. With the extra food, you could go back to 100% consumption and live a slightly better life, but to achieve an even better standard of living, you would need to continue to save and continue to defer consumption.

Why This Is Crucial

It is saving and producing that should be the focus in order to grow an economy. Sustainable increases in

Production

Production

consumption are a symptom of an economy that has already grown and produced more, not the cause of prosperity.

GDP is merely a statistic. Although it is not a bad thing per se, what gets measured also gets managed – even manipulated – by governments. Telling the populace that consumer confidence is high and consumer spending is up can make an economy look stronger, inducing governments and central banks to continue to pursue policies that boost spending.

Indeed, not only are central banks continuing to try to keep interest rates low and stock markets high to produce a “wealth effect” of more debt and more spending, but governments are also considering additional spending measures (government spending is also counted in GDP).

Investors need to remember the true causes of wealth creation, and seek to protect their own wealth in the face of a government-managed economic environment.

Why are Interest Rates so Low?

Higher Interest RatesWhy are interest rates so low?

Ask most people on the street why interest rates are so low, and they will reply that central banks are
responsible. Okay, perhaps most people have no idea about interest rates or central banks and would likely shrug their shoulders, but regular blog readers are certainly aware of all of the central bank actions to try to keep rates low!

However, academics and economists are increasingly opposing this commonly held notion, countering that interest rates are affected by more powerful market and economic forces than central banks, contending that the decline in productivity is causing rates to be low. Therefore, which theory is correct? The answer may be both – and linked to the same cause.

The ‘natural’ versus ‘market’ rate of interest

To understand what may be going on, we need to go back to the 19th century economist Knut Wicksell, who differentiated between the ‘natural’ rate of interest and the ‘market’ rate.

Interest rates are a type of pricing and, like prices, they signal the relative supply and demand for something; in this case, the supply and demand for loanable funds. The natural rate of interest is the equilibrium rate that balances the amount of money to be loaned and borrowed, or the level of savings and investment. This natural rate therefore coordinates economic activity much like prices coordinate activity.

Like other prices, the equilibrium or natural interest rate that correctly balances economic activity cannot be known by someone. Only the market process can bring it about, and it is constantly changing and adapting to different conditions.

The natural rate of interest is affected by real economic forces; people changing their preference for saving versus taking on debt, or consuming now versus later. But the market rate is the rate that is the prevailing interest rate, influenced by central bank actions as they target various rates to be lower.

Central banks claim they want to set the market rate at where they believe the natural rate to be, in order to bring about a balanced economy. But this is an impossible task. Just as no central planner knows the correct price of steel or milk, so the Federal Reserve does not know the correct interest rate to set in order to coordinate economic activity.

It is this very attempt at setting rates that causes so much economic upheaval. If the Federal Reserve sets rates too low (or too high), misallocation of resources will occur, typically in the form of inflation, bubbles and then subsequent crashes.

Is the Federal Reserve the perpetrator of low rates?

A main criticism to this theory is that interest rates have been low now for quite a long time, and therefore there is something else going on besides the Federal Reserve and other central banks keeping rates low.

In other words, such critics believe the natural rate of interest is actually very low and has been declining, therefore the Federal Reserve is merely setting market rates to be consistent with this low natural rate level.   

One of the reasons cited for the decline in the natural rate is the decline in productivity of American workers and the general sluggishness of the economy. However, this may actually be a symptom of the previous boom and bust caused by erroneous central bank actions, rather than an unrelated factor.

The Fed set rates too low

The Federal Reserve fueled the unsustainable boom prior to 2008, and we are still feeling the negative effects today, such as  lower productivity. Because the Fed set market rates below the natural rate, misallocation of resources occurred. Instead of allowing those resources to reallocate themselves to better uses (such as out of housing and banking), the Fed was intent on keeping the status quo and avoid liquidations and bankruptcies.

The Bank of International Settlements (BIS) suggested this possibility in their recent annual report, noting that low interest rates could actually cause a cycle of lower productivity:

“Alternatively, persistently low yields could end up having pernicious effects on the economy and become to some extent self-validating… They may also distort financial and real economic decisions more generally, for instance by encouraging unproductive firms to maintain capacity or by inflating asset prices, thereby weakening productivity.”

We see this when we examine so-called zombie banks that continue to hold bad loans on their books in order to avoid the charge-offs. We also see factories and retail stores that continue to operate because the Fed has incentivized consumers to continue to spend, rather than cut back on spending, repay debt and save.

Central banks should stop meddlingRate Hike Calculator Words Increased Interest Cost Borrow Money

In conclusion, there are certainly other factors and forces that determine interest rates, besides the central banks. But lower productivity may actually be a logical outcome of previous low rates set by central banks. This is precisely why central banks should get out of the business of trying to set the correct interest rate, just as Soviet central planners had no business trying to set the price of eggs.

What does this all mean for your investment portfolio? As long as central banks try to guess at what interest rates “should be”, they will fail. This will cause continued misallocation of resources, and therefore investors need to be aware of continued instability such as inflation, bubbles and crashes.