Monthly Archives: February 2017

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!

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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!