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Weekend reading: Will the passive investing revolution eat itself?

Weekend reading: Will the passive investing revolution eat itself? post image

What caught my eye this week.

Like anyone who understands the mathematical case for index funds, I find the attacks against them almost universally spurious.

As Rick Ferri wrote this week on Forbes:

The truth about index funds must be repeated often because lies are constantly being told. They are successful because they are good. Those who cry wolf either don’t know the truth or have a strong financial incentive to ignore it.

Happily, the message seems to be more than getting through. The Abnormal Returns blog noted this week that with US equity passive and active strategies now having equal amounts of trillions under management, the question is how much further passive investing can grow.

Before we get carried away, I’d note that much of those ‘passive’ trillions are in ETFs. And ETFs are often used as trading vehicles by fund managers. So it’s unclear to me whether more than 50% of invested money really is lying on a metaphorical sun lounger, accepting the market’s return while its owner does something more interesting instead.

Nevertheless, the direction of travel is clear. Ever more investors are passively accepting what the market gives them – minus tiny fees – and building long-term financial plans around that reality.

What’s the catch?

This brings me to an interesting opinion piece in the Financial Times – and also to the only push back against the rise of index funds I’ve ever found persuasive.

Starting with the latter, occasionally someone says something like:

Index funds make all this too easy. I can put my money into an all-in-one passive equity and bond fund, leave active investors to make all the hard decisions, and take 8-10% a year? It is too good to be true. Stuff like that usually ends badly in the financial markets.

And this touches a nerve because… I sort of agree. When something works too well investing, with too little downside, well, sooner or later it usually blows up.

Now of course index funds do come with downside. Shares definitely go down as well as up!

I hear people, especially in the US, saying stuff like “I play it safe with my S&P 500 index fund and don’t take too many risks”.

That is a ten-year bull market speaking.

But let’s put normal volatility to one side. There is still an inherent tension with index funds in the strategy being the easiest AND cheapest AND biggest AND YET it relying on a shrinking supply of people doing the most expensive thing, which also happens to be the hardest, for overall lower returns.

Then again, tension-schmenshion – active investing is a zero sum game. That won’t – can’t – change.

So how does too-good-to-be-true resolve itself?

Let them eat bonds

Back the FT article [search result] where author John Dizard compares confident equity investors to the indolent aristocrats of the French Revolution, adding:

The retirement savings/investment industry is promising the creation of a class of notionally idle, ie retired, people which will be at least an order of magnitude larger as a share of the population than la noblesse.

This group would be with us for decades alongside a stagnant (at best) working-age population.

At the same time Prof Siegel and the equity cult would ‘reform’ state entitlements so those without equity portfolios have to perform real work up to and even through their 70s.

The statistical construct of eternally compounded 6 per cent-plus investment returns has allowed upper middle class people to believe this Disney movie.

Doesn’t Dizard have a point?

At least active investing looks like work.

At least in the old days a saver giving their money to a fund manager looked like a risk-taking investor.

And at least ducking in and out of the market in a futile effort at market-timing looked like skill, risk, and reward at play.

Sure in reality we know the market’s aggregate return is the same, whether the money is investing passively or actively, ignoring fees.

But if the woeful politics of the past few years have taught us anything, it’s surely the importance of optics.

Perhaps the Achilles’ Heel in the kind of dial-it-in global-tracking we champion on Monevator could be political backlash, rather than bogus mathematics?

I’m not convinced but it’s worth a ponder.

What do you reckon?

From Monevator

Why your life expectancy is probably much longer than you think – Monevator

From the archive-ator: Why does Joe Public love sweatshops? – Monevator

News

Note: Some links are Google search results – in PC/desktop view you can click to read the piece without being a paid subscriber. Try privacy/incognito mode to avoid cookies. Consider subscribing if you read them a lot!1

Pound marks longest losing run against the Euro since trading began in 1999 – ThisIsMoney

Digital banking app Loot goes bust after it fails to raise more funding – Moneywise

Facebook and City banks among the highest-paying UK firms – Guardian

Index companies to feel the chill of fund managers’ price war [Search result]FT

An interview with the founder of the (would-be) Long-term Stock Exchange – Vox

A reminder: Average returns are rarely what you get in any given year – Independence Advisors

Products and services

Investors itching to switch kept waiting for up to a year [Search result]FT

Facebook plans to launch ‘GlobalCoin’ cryptocurrency in 2020 – BBC

How to earn cashback on every £1 you spend – ThisIsMoney

Ratesetter will pay you £100 [and me a cash bonus] if you invest £1,000 for a year – Ratesetter

Reassessing Vanguard Lifestrategy funds from a climate emergency perspective – DIY Investor

Natwest does a U-turn on 0% credit cards, launches new offering – ThisIsMoney

Compact homes for sale [Gallery]Guardian

Comment and opinion

Stop the financial pornography! – Of Dollars and Data

Not my priority – Humble Dollar

What’s the best diversifier for equity risk? [US but relevant]Morningstar

How to pass on your wealth without paying the taxman – ThisIsMoney

How to plan your finances if you or a loved one has dementia – ThisIsMoney

What happens after you achieve financial independence? – Get Rich Slowly

Why are other investors so biased? – Behavioural Investing

Larry Swedroe: Factors are for holding – ETF.com

Nick Train, Terry Smith, and some other famous fund managers offer tips – ThisIsMoney

A takedown of technical analysis – Mathematical Investor

Tucking into Domino’s Pizza shares – Sharepad

How inflation makes the value factor a sector bet – Fortune Financial Advisors

Broken homes produce more cautious fund managers – Institutional Investor

Brexit

May ends as she started: With the greatest lie of all – Politics.co.uk

What does Theresa May’s resignation mean for Brexit? [Search result]FT

Stand by for a summer of Tory fratricide and country-shafting – Guardian

Kindle book bargains

My Morning Routine: How Successful People Start Every Day Inspired by Benjamin Spall – £1.99 on Kindle

Reset: How to restart your life and get F.U. money by David Sawyer£0.99 on Kindle

So Good They Can’t Ignore You by Cal Newport – £0.99 on Kindle

The Personal MBA: A World Class Business Education in a Single Volume by Josh Kaufman – £1.99 on Kindle

Off our beat

Impossible Foods’ rising empire of almost-meat – Engadget

Tips on networking from an anxious venture capitalist – A Berg’s Eye View [h/t Abnormal Returns]

10 inspirational newsletters that will improve your life [allegedly]Fast Company

Seven climbers die after getting stuck on an overcrowded Everest – BBC

And finally…

“Everyone sees what you appear to be, few experience what you really are.”
– Niccolò Machiavelli, The Prince

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{ 54 comments… add one }
  • 51 Haphazard May 27, 2019, 6:27 pm

    Apologies for interrupting the great debate on passive investing.

    I just wanted to make a quick comment on the FT article on switching platforms.
    The model adopted by e.g. Interactive Investor means that you pay a fee from the moment you open an account – even if there is nothing in it. Because they’re not charging a percentage of assets or a fixed fee for trading – but a fee for having an account.
    This means that if you are switching in, presumably you can be paying away for months, to two platforms, one of which holds no assets at all!

  • 52 Richard Brooksby May 28, 2019, 8:21 am

    If passive funds are run by algorithms and 100% of investment were in passive funds, then the algorithms will be setting equity prices by trading among themselves. That’s likely to be an unstable solution using current algorithms, but the result of this could be determined by simulation.

    It’s rather like if you take all the players out of a multiplayer on-line game and replace them with bots.

    Now, a clever person can exploit the situation where all the players are bots. Not necessarily by playing against them directly (they could have superhuman reaction ability) but by programming bots that take advantage.

    Thus, we enter an era of indirect gaming, where players are competitively developing bots to play the game for them. So far, this requires humans. But a few humans can control many bots.

    So I suspect the future is that the markets are operated by algorithms developed by a few humans, and almost nobody is directly making trading decisions. Meanwhile, companies that want investment will be gaming against the algorithms to get it.

  • 53 The Compounder May 28, 2019, 8:44 am

    My opinion is that this simply isn’t a problem, because passive investing products are sufficiently diverse in their approach to make the market function normally. Some are market cap weighted, some dividend, some momentum, etc etc. Furthermore, let’s not forget that active investing has a place – for a low fee, and will not disappear. Even Vanguard believe there is a place for active management.

  • 54 Matthew May 28, 2019, 9:31 am

    @richard – i dont think theres much left to be exploited, when you have trading bots vs indexing bots and any -known- inefficiency is arbritaged away (ie index front running or currency arbritage) – human traders simply wouldnt be able to act as quickly but could understand qualitative information better, and ego/careers will always make a place for them

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