Indexing vs. Active: Has Passive Swung too Far?

Thanks to their lower cost and ability to trade during open market hours, Exchange Traded Funds (ETF) have been taking investment dollars away from actively managed mutual funds since they came into existence in 1989. While the number of ETFs has exploded into many hundreds of sectors and sectors into finer and finer slices, the most popular remain those tracking the broad indices such as SPDR S&P 500 (SPY) and Powershares QQQ (QQQ).

The trend of index or “passive” investing accelerated following the financial crisis and seems to now represent a generational shift in the way investors approach the stock market. Namely, they don’t necessarily trust it or those who dispense advice, but they acknowledge stocks are still one of the best ways to build wealth. And most importantly, they are happy to simply track, rather than beat, the overall market.

And given the performance of most money managers, including hedge funds, it’s no surprise passive may be sapping money from high-fee, poor-performing funds. The fact is for most people with a long time horizon, taking a buy and hold approach makes sense; simply by making the decision the market is going up and to be invested can be considered sufficiently “active.”

This is evidenced by a recent study by S&P Dow Jones Indices, which found excellent performance is really hard to replicate year-in and year-out. Using University of Chicago’s Center for Research and Security Prices (CRSP) mutual fund database of 2,300 active stock funds and their performance from March 31, 2000 to Sept. 30, 2016 they concluded, “We observe little to no evidence of performance persistence among active managers, except in the large-cap value and real estate categories” the report reads.

Out of 1,034 large-cap funds in the universe as of Sept. 30 2013, a little less than 20% or 204 funds beat the S&P 500. The next year only 15% of the 204 beat it. By the third year, there were none. Basically, performance chasing almost never works.

Who’s the Sucker?

One of the challenges for active managers might just be that shift towards passive investing, as it becomes not only self-reinforcing but also makes rising above the pack, or creating beta, more difficult.

On the first notion, as more money flows into ETFs they mechanically purchase more shares of the largest and best performing stocks which in turn drives the prices of them higher; a nearly virtuous cycle which has helped large cap stocks accounting for the bulk of the S&P and Nasdaq’s performance continue to deliver the best gains.

Those small cap or value-oriented companies remain just that, small, undiscovered, underinvested and therefore “undervalued.”

This speaks towards the other aspect of how the pervasiveness of passivity makes it more difficult for active managers. Think of the poker table analogy with the old saying, “if you don’t know who the sucker is at the table, it’s probably you.” As more retail traders have exited active trading it has left professionals to duke it out among themselves; meaning more competition and less easy money.

Still Room to be Great

While I think indexing is great and it’s what most people should do, I think there is still room for do-it-yourself investing. In fact, like most market trends I think passive indexing is getting close to singing too far and will open the door back up for active managers to outperform the broad market.

At some point the performance of passive indexers will reach diminishing returns; at some point everyone will become invested in the same stocks, stopping prices being driven higher.

At that point stock picking will once again become paramount. The best performing stocks of the last 10 years were all easy to discover and buy if you check the all-time high list even once a month. If you had a pulse, Netflix, Google, Facebook and Amazon were on your radar.

But there were others you might have dismissed such as Green Mountain Coffee Roasters, and Monster Beverage, which both were initially perceived as niche products only to grow into multibillion businesses that Coke (KO) paid a premium to acquire in 2015.

What do all of the above stocks have in common, other than being able to grow their earnings and sales in an impressive manner? They spend a lot of time on the 52-week highs list and set up multiple times.

Netflix was also a niche business Blockbuster could have bought for a mere $50 million in 2001, but just didn’t see the future. Now it’s worth $62 billion for a 4,400% return. Of course you would have needed the fortitude to hold through steep drawdowns.

Similarly, a few years ago Bitcoin came on scene, soared above $1,000 before tumbling in half and being dismissed as a bubble. Today it is back above $1,200 and not a peep from the bubble callers. And in a case of the tail wagging the dog an ETF based on the digital currency is in the works, which will allow not only allow bulls and bears to battle it out but should probably accelerate its adoption and application.

There will always be great new businesses coming along and I would argue the more people index today, the more those companies will initially be overlooked, creating better opportunities for active investors.

Like most things, once the pendulum swings too far one way, the greater the swing back the other. One day we will see towards active.

— Steve Smith

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About the Author: Steve Smith