Pitfalls of Passive Investing

From humble origins in the early 1970s, index investing has become the 800-pound gorilla of investments. First derided, then accepted as a technique, these days, money moves out of active equity management and into passive vehicles every day.

Vanguard launched the first retail index mutual fund in 1976. After reaching $100 billion in assets in 1999, today it holds more than $4 trillion. In the past 10 years, passive funds have gained $1 trillion in asset flows while active funds have seen outflows of the same amount. 

As an active investor, I may have a bias. I will admit to using passive strategies when appropriate. But I think passive has evolved well beyond its original design and purpose. 

What if our beliefs about index investing have been formed under ideal conditions? Is it the proverbial free (or low-cost) lunch, or is it somehow less than advertised? Could different circumstances lead to disappointing outcomes?

The answers depend on how well the implicit and explicit bets of passive investing pay off.

Origins

The original premise of passive investing was simple: Hold the broad market, or most of it, weighted by capitalization, and keep management fees as low as possible. Since the market return is equal to the gross return of all investors before fees, this strategy should always do a little better than average.  

The concept was not immediately popular. In the 1970s, the US market was volatile and return dispersion was high. Small-cap stocks outperformed large caps and the relatively small universe of professional managers was able to generate alpha at the expense of less sophisticated or less fortunate investors. Many prominent mutual funds delivered returns better than index benchmarks. 

In the 1980s, unsophisticated investors became less active, leaving less alpha to be harvested from outside the manager universe. The number of mutual funds exploded, growing faster than the talent pool and diluting returns.

Larger companies also began adapting to the new global environment, and their shares were relatively cheap. A wave of buyouts and takeovers ensued, igniting better performance for them and the cap-weighted indices. Indexing became more popular as improved returns for large-cap companies drove better relative performance.

From today’s vantage point, it seems obvious that an equity investor should have overweighted large-cap names and simply held on through every decline, because the indices have always come back to make higher highs.

But every strategy’s performance is end-point sensitive. Just because that was the optimal choice from 1982 through 2017, are we assured that it will continue to be the best path moving forward?

Potential Pitfalls

Index funds explicitly bet that today’s largest companies will outperform in the future. But look at a list of the largest companies of 1999 or 1985 or 1970 and see how many names you recognize.

In a dynamic, innovative economy, smaller companies should gain some advantage from being able to react more quickly. The 1970s were such a period. Rising inflation and declining global competitiveness hurt mature industries and large companies that had grown during the 1950s and 1960s, under different conditions.

Today’s giants have capitalized on globalization and have been handicapped less by regulatory costs, but those advantages could easily fade in the future. 

Active managers tend to weight positions without regard to total market capitalization. This produces better diversification and risk management, but introduces a capitalization bias. When the largest companies outperform, most active managers will lag. Money flows to the best-performing managers, including index funds.

Redemptions force an active manager to sell its holdings. Index funds take this cash and buy more of their portfolio, especially the largest companies. At the margin, this cycle benefits the relative returns of passive over active, which tends to keep the money flowing in this direction. 

A major contributor to the success of passive strategies has been the extended outperformance of the largest capitalization companies, aided and abetted by money flowing into these same strategies (to some extent due to performance). If performance reverses, this money could flow out and relative performance could lag.

Historically, the relative returns of active managers have improved during bear markets and look their worst after extended bull market runs—like today. Prudence and caution only detract from returns in a bull market, particularly if declines are brief and shallow and are quickly recovered.  

What if the next bear period is longer and deeper? What if it looks like the slope of recovery will be disappointing? The pleasure of riding indices to ever-higher levels becomes the pain of loss. Incentives to buy and hold turn into incentives to sell and hide.

Active managers can hold cash or underweight the most vulnerable stocks and sectors. In short, they can play defense in ways that passive strategies cannot. Since the last bear market ended eight years ago, short memories may contribute to investors’ fondness for index funds.

With indices at all-time highs, the 35-year bull market makes passive strategies look more successful by diluting the impact of declines. Future performance may not be so blessed.

Reaching the Limits

Any time an asset class or strategy becomes over-loved and overbought, it sows the seeds of its own demise. Witness the examples of housing and related securities in 2008, internet stocks in 2000, precious metals, the Nifty Fifty, industrial conglomerates, and so on.

Whatever the cause, extended periods of outperformance reach their limits. Bubbles either pop or deflate slowly, and neither scenario is pleasant. What could cause large-cap US equities (and passive strategies) to underperform?

For decades, the US economy has enjoyed exceptional tailwinds spurred by demographics (the Baby Boomer generation) and leveraged by increasing debt. Over the next 20 years, the US workforce will barely grow (and the workforce will shrink in Europe, Japan, and China). Productivity growth has fallen well below trend and shows no signs of improving. Debt growth is likely to slow and in any case, the marginal return on debt is falling globally. Even the coordinated global central bank liquidity conspiracy is winding down. With equity valuations at levels typically seen only at market peaks, future returns should fall well below the trendline and most investors’ expectations.

While there are undoubtedly purist passive investors who will accept whatever the future provides, others have an expected rate of return hurdle. Most pension plans, endowments, and individual investors expect equities to provide at least 7% or 8% returns. As long as the market meets or exceeds this threshold, the risk of shortfall dominates the potential reward of doing better. 

But if long-term return prospects deteriorate, strategies that can promise something better become more attractive. Money could begin to leave index strategies in favor of active managers, bringing selling pressure upon the largest names that have benefited the most from inflows.

Passive strategies implicitly assume that average returns will be sufficient to meet investors’ goals and that the risk of falling short of this benchmark exceeds the potential rewards from outperformance. 

Passive investors assume that large-cap stocks will grow faster than smaller ones, that passive inflows will continue, that market declines will be brief and recoveries prompts, and that the broad market averages will continue to provide 7% to 8% returns despite changing conditions.

They count on the future being like the past 35 years.

Despite the theoretical appeal, these seem like poor bets today. And yet investors can make it even worse.

How To Make It Even Worse

Wall Street excels at designing marketable products of dubious value to clients. Insatiable demand for passive strategies has led to the introduction of “passive-like” derivatives, many packaged as exchange-traded products (ETP). Some offer exposure to a sector or industry, some to purported alpha factors (“smart beta”), and some leverage gains or produce inverse returns. All introduce varying degrees of active decisions.

Of some 2,000 ETPs listed today, only about 1% are true broad market passive products. The rest implement some sort of active bet. Unsurprisingly, the fees are higher, and furthermore, the average holding period on these ETPs is measured in weeks. Active trading incurs direct costs from commissions and market impact as well as triggering taxes.

The proliferation of faux-passive products has enabled sector- and factor-picking to substitute for stock picking, but investors who lack the skill for the latter are unlikely to succeed in the former.  

Finally, losses from ETPs will likely be magnified due to the hidden risk of phantom liquidity.

When possible, a buyer of an ETP is first matched with a seller. Net inflows require a broker called an Authorized Participant to buy shares in the market to create ETPs in bulk. When supply and demand roughly balance, liquidity is provided at the ETP level, reducing transactions in the underlying securities.

However, net redemption of ETP shares eventually requires selling the actual underlying shares, which may be less liquid. Lower prices here lead to markdowns at the ETP level, which may in turn lead to more selling pressure.

Holding through the downturns (even buying the dips) is easy to endorse in theory, but much more difficult to put into practice when watching value disappear daily. 

While exchange-traded products may resemble passive strategies, their real-world implementation involves higher fees, more active bets, faster trading, and tax inefficiencies that virtually guarantee that the aggregate of investors in these vehicles will suffer substandard returns.

The Reality of Passive Equity

Passive equity investing offers lower management fees, reduced turnover and transaction costs, and the possibility of tax efficiency. By being roughly average, it greatly reduces the possibility of exceptionally bad performance.

However, like any strategy, it is a product of its environment. Its performance track record has been built under ideal conditions—a 35-year bull market in which large-cap names have outperformed smaller companies, and inflows to passive strategies have attenuated the large-cap advantage.

But for the past five years, equity valuations have expanded despite very little growth in earnings or revenue, and by many measures, they sit at historic highs. If future earnings growth remains substandard and valuations migrate toward more normal levels, absolute performance could suffer. Money drawn to active strategies for performance reasons could leave as easily as it entered, and outflows could depress relative returns.

When equity indices provided total returns well in excess of required hurdles, the risk of falling short dominated the potential gain from active management. But if return forecasts decline to inadequate levels, more investors may feel compelled to leave the security of passivity and find managers with the skills to outperform.

About the Author

Glenn Fogle, CFA, is chief investment officer for Drawbridge Capital in Tulsa, Oklahoma. Previously, he was a portfolio manager for American Century Investments for 17 years.