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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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{ 53 comments… add one }
  • 1 MrOptimistic May 24, 2019, 3:46 pm

    If everyone invested via index funds, what would set the price of the components?

  • 2 FitandFunemployed May 24, 2019, 5:20 pm

    Essentially, at the very broadest level, I think you’re saying that the perpetual growth is unsustainable. Well… duh (sorry).

  • 3 Fay May 24, 2019, 5:42 pm

    I’m a newbie to this FIRE movement. I live in the U.K. (United Kingdom). I know Mr MM takes about investing all your money in vanguard. What is the equivalent in the U.K. please could you direct me to the relevant article as I would really like to invest my savings. Thank you

  • 4 The Investor May 24, 2019, 5:52 pm

    @FiF — I’m not really saying that. Obviously we can get to max 100% passive. As for equity growth, that can continue indefinitely, presuming productivity gains, etc.

    What I’m saying is perhaps something in approaching passive ubiquity will prevent that ubiquity. Something political.

  • 5 ermine May 24, 2019, 6:36 pm

    @Fay go take a look at Lars Kroijer’s series on here. Or go to the menu, choose investing, and take the passive investing subhead

  • 6 The Borderer May 24, 2019, 6:41 pm

    @Fay

    We all had to start somewhere. I suggest you start here – https://www.youtube.com/watch?v=Q_ZGNQwSSG8

  • 7 Anonymous coward May 24, 2019, 7:18 pm

    Surely this debate matters a lot less now that unit trusts are no longer asking 5% up front and 5% a year to invest your money for you? Those capable of making an informed decision about passive vs active can make an informed decision. For those that can’t, nobody ever went broke from buying Artemis or CTY when they could have bought VUKE. The benefit of feeling that a human being rather than an algorithm is doing your investing may be illusory but it is still a benefit if it makes you more comfortable with investing, and the difference between VUKE and CTY is microscopic compared to the difference between investing and not investing at all.

  • 8 Matthew May 24, 2019, 7:20 pm

    Passive isn’t too easy, it requires you to sit on your hands and not itch, it requires you to swallow your pride in a very pride orientated market, it requires you to have the foresight to see past financial advisors and it requires a mind that works in probabilities and tolerates risk.

    That’s why there is still so much more active than there ought to be.

    Pension funds should be indexes by default, I think, otherwise putting disproportionate faith in one fund manager could be seen like a form of corruption, essentially, since these people aren’t giving an opinion on who should run it, we shouldn’t assume for them

  • 9 Dave @ Accidental FIRE May 24, 2019, 9:11 pm

    Too good to be true? Ending badly? I’ve been in the Vanguard S&P 500 Index for 24 years now and it’s rewarded me with financial independence and the ability to go part time at my job or stop working all together in m y 40’s.

    Go ahead, keep thinking that… more for me.

  • 10 The Borderer May 24, 2019, 9:19 pm

    @Matthew

    My wife held a very senior finance position in the university sector. Despite my views to the contrary, and the evidence that’s there for all to see, (which she agreed with), nevertheless her university invested in active funds, and what’s worse, through an investment manager. So fees on top of fees.

    Her reason? It has to be seen to be a safe, sober, non-speculative investment of public funds. I suspect pension funds are operating in the same way. I can see the red top headlines “pension fund loses millions investing in Japan (Korea, India etc etc)”.

    It’s what happens when bureaucrats and/or the ignorant manage things.

  • 11 The Borderer May 24, 2019, 9:24 pm

    I didn’t mean my wife was a bureaucrats and/or ignorant, but she answered to them.

  • 12 Matthew May 24, 2019, 9:46 pm

    @theborderer- indeed I was looking into the regulation for how charities are allowed to invest (was considering setting up a charity that used investment only) – and it pretty much was forced active management – theyre forced to use advisors, forced to review performance, etc – a prime example of the unintended consequences of well intended legislation made by people who don’t really know, and its why individuals can achieve more.

    So basically all that wiped out the tax advantage of charity status. I regard charities now as effectively an arm of government – taxpayer funded, public serving, red tapey

  • 13 Matthew May 24, 2019, 10:26 pm

    I wonder if forced active management for pensions etc is enough to distort the market such that prices arent what they should be, hence why negative bond yields occurred in some places. Arguably a truely passive approach would have the same asset allocation of the world, not according to risk tolerance, so tilting your equities for extra/less risk is not so different than diverging away from planet earth’s asset allocation

  • 14 Lord May 24, 2019, 11:05 pm

    I like the article by the mathematical investor on technical analysis. In my early days of investing I wasted a lot of time on this, and, as the article states, the prevalence of technical analysis amongst the media, investment platforms, and other places, can give the impression that it is what you need to do if you interested in investment.

    I would like to think that there is better information available these days on how to go about investing, and the Abnormal Returns piece on ETF growth is encouraging. I look back now and think of the lost dividends and capital gains I missed through trying to understand resistance levels, head and shoulders patterns, candlestick formation, and other such trends.

    I suppose it’s part of the investment journey and we all make mistakes and errors along the path, some more embarrassing than others. Ho hum.

  • 15 Naeclue May 24, 2019, 11:12 pm

    I read the FTSE article and don’t really understand why you say it is an attack on index funds. As far as I can see all it is saying is that the equity risk premium can suffer long periods when it underperforms bonds. Surely this should not be a surprise. The clue is in the name – Equity “Risk” Premium. Risk means uncertainty. Uncertainty that you may not get the expected return. If taking equity risk guaranteed a better return than bonds there would be no risk, and we would just be left with “Equity Premium”.

  • 16 IanH May 25, 2019, 12:25 am

    It seems to me the active / passive dichotomy hinges on whether one is open to the notion of ‘accepting average returns’. The last conversation I had with my IFA reflected precisely this – I wouldn’t want average performance would I? Well, actually that would be great thanks. And I’ll keep the 4 grand in annual fees as well, if you don’t mind.

  • 17 MR WG May 25, 2019, 2:42 am

    @Fay, good luck with starting your investment journey. If you want to keep it super simple and only start by investing a small amount of money each month, you could consider Vanguard UK Life Strategy.

  • 18 Ben May 25, 2019, 8:00 am

    @TI it sounds like you’re changing your mind in one area that I strongly disagree with you. Namely that capitalism would be fine with just a few enthusiasts like yourself allocating the world’s capital (half of whom are paying for the privilege).

    We don’t need all the world’s intelligencia on the case but we do need a lot of them.

    IMO the rate that money is going passive is a genuine threat to the established order.

  • 19 Passive Pete May 25, 2019, 8:14 am

    I was a pension fund trustee for many years for my last two employee companies. The trustees of all pensions are governed by the Pensions Act which requires that the trustees take professional advice on choosing where to invest. Guess what the professionals always recommended!
    It took me several years of sitting at trustee meetings with investment managers explaining their underperformance before I grew the balls to tell the professionals that we wanted a passive fund. They kicked back but I eventually won.
    It’s more important where the scheme is a defined contribution rather than defined benefit. In a DB scheme the sponsoring company would be responsible for any shortfall. I guess that’s the same for public sector schemes too – so we all end up footing the bill for underperformance in these schemes!

  • 20 The Investor May 25, 2019, 8:17 am

    @Naeclue — Morning! 🙂 Yes, it’s not specifically about index funds, it’s about the equity risk premium. I extended the thought/article. I think I said as much in my brief post above? (I’m on the phone and away from my desk for the long weekend so a faff to check.)

    Regarding me changing my mind or whatnot and other comments, I’m not particularly, just having a muse. 🙂 As I (think I!?) stated the “too good to be true” grit has been needling away in my shoe for years. Having used a tracker for 20+ years is small beans in this context. This, as @Ben alludes, would be a systemic issue, akin to New World silver crashing the Spanish currency or the post-plague breakdown of feudal ties/labouring. 🙂

  • 21 Ben (other) May 25, 2019, 8:32 am

    @Ben

    I’m trying to work out your difference of opinion. That TI thinks there needs to be very few active participants (<1%) , and your saying you need a large minority at least (50% trading activity with absolutely no effect on (true) price finding ability whatsoever, it just might take 5 seconds, rather than 0.0000001 seconds.

  • 22 Father Dougal May 25, 2019, 9:16 am

    Luckily, human nature will ensure that there will always be active investors, so there will always be a market providing “price discovery”. There is an interesting (at least to me) parallel with the copper market. The London Metals Exchange sets a daily reference price through an auction involving a limited number of participants. The world market for copper then uses that reference price for contracts. I think even if indexing grows we will still have a significant market to value equities.

    A concern I find more persuasive is about corporate governance. If most of the market is passive, who holds the scoundrels to account by engaging with management and voting against the board when necessary? (Although it must be pointed out that the investment industry has not exactly been effective at dealing with issues such as executive pay.) I heard that Vanguard is looking at becoming more engaged with management and it was an issue raised by Jack Bogle.

  • 23 Hariseldon May 25, 2019, 9:17 am

    With regard to the cost of active investing compared to Passive, we recently received new style statements from HL, with the cost of investing expressed as cash amounts.

    (Last summer I made a tactical move from my Passive approach to include a substantial tactical allocation to investment trusts because I thought B****t would have been resolved one way or another by now…. I was wrong ! I reversed the move recently.)

    The assumptions are that you held the present holdings for a year, five figure cash sums in total grab your attention, the Passive elements were dramatically less, not a surprise but it got my attention!

    To be fair to the Investment Trusts some of the costs quoted seemed far higher than the costs when I looked at annual reports on a few of the trusts.

    PS note to self , Market timing is not a good idea, I was fortunate that the whole exercise was fairly neutral with regard to costs due to fortuitous timing on the switchback.

  • 24 John @ UK Value Investor May 25, 2019, 11:15 am

    Whether a fund is passive or active is defined by who makes changes to the portfolio:

    Passive funds (like index trackers) are changed by an algorithm, active funds are changed by a human.

    But this definition doesn’t say anything about the actual investor (i.e. us), and I think most ‘passive’ investors are actually active.

    I certainly was when I was a ‘passive’ index investor in the 90s. I invested passive during the bull market, and then sold actively when the dot-com bubble burst. I’ve seen other ‘passive’ investors do this in the 2008/2009 crash and they’ll do it again when the market crashes again.

    In fact, if all investors were truly passive, investing in index trackers and only buying when they had savings to invest and only selling when they were drawing down funds (primarily in retirement) then there would be no bull markets or bear markets because, I assume, the net in and outflows from savings and drawdowns are very stable year-to-year.

    Does anyone really think we’ll have a world of equities returning 6%-10% per year with almost no volatility? No, of course not. Therefore equities will always have high volatility which is driven primarily by investors (me and you, not fund managers), buying because things are going up and selling because things are going down. That’s active investing by definition, so no, the majority of investors aren’t and probably never will be ‘passive’, regardless of whether they invest in index trackers, actively managed funds or individual shares.

    (on re-reading that, some of my tone sounds a bit harsh, which it isn’t intended to be)

  • 25 Naeclue May 25, 2019, 12:14 pm

    Ok, I think I see what you mean. Active investors put all the effort and bear the cost of creating an efficient market. Passive investors come along and say oh look an efficient market, I will buy into that, whilst contributing nothing to its cost and to a degree, deriding those that help create the market. This does not sound like a sustainable situation.

    On the other hand, a lot of the so called passive funds are not passive market weighted funds. There are a lot of smart beta, etc. Funds that filter, weight other than by cap weight and regularly trade stocks. These funds must contribute to market efficiency, although they probably do not contribute their fair share of costs.

  • 26 James May 25, 2019, 12:24 pm

    I really do not think it’s 50/50 at all and as a % of the population who really has the balls to go all equity or 90% and sustain it? I do not know anyone other than myself band my now convinced brother

    Even people heading toward retirement take their pensions out “risky” assets

    Being passive is not easy at all and that is why this whole theory is a foolish theory

  • 27 Matthew May 25, 2019, 1:09 pm

    Perhaps the regulation that forces pension funds and charities etc to be active is a good thing that shouldn’t be changed, to make sure someone is always pricing the market, also the fees they pay will be somewhere in the economy; passive investors may naturally own the advisor companies and active managers charging it, and the companies selling sports cars to fund managers…

  • 28 old_eyes May 25, 2019, 1:14 pm

    Interesting article and comments. I for one did not appreciate how the rules on pension funds influence the active/passive investment ratios.

    I think there is a political risk to our endeavours, but I don’t think it is active vs passive, I think it is the difference in many minds between being paid for the service you provide to someone else (having a job or running a business), and making money by enabling other people’s economic activity by investing (rentier behaviour).

    As a partial and mildly early retiree, I find that many think that since I am doing no ‘real’ work, the income I receive must be in some way illegitimate and theft from the productive economy. It could be just normal human jealousy, but there is also an unwillingness to accept the decisions I made in my life that led to this happy state.
    Now I know just how much luck was also involved in being able to reach financial independence, but there was also a lot of work at the coalface and deferred pleasures that enabled me to reach FI when contemporaries did not.

    So I see the risk as an attack on wealth rather than active vs passive investing. It will be the ‘unearned income’ model rather than a specific type of investment.

    Some of the comments distinguish passive and active by algorithmic vs human decision making. I think that is wrong. Every strategy used by investment managers, from various combinations of letters in the greek alphabet, through graphs of every known shape, right up to tossing a coin or examining the entrails of chickens, could be dealt with by computer. We just started with passive funds because it is easier to program. In the future, I am sure that you will be able to make a full range of investments supported by software that operates a strategy of your choice, and many people will choose to go with TerrySmith v3.6 or whatever.

    I think the costs of active and passive funds will converge because there will be less human decision making and more computerised decision making. Back in the 1930’s Ronald Coase showed that the shape of a business and its interactions with both customers and suppliers is strongly influenced by transactions costs. If you don’t reshape your business to take advantage of reduced transaction costs (computerisation in this case) you are probably not long for this world.

    As a sidelight on Brexit, a large part of the UK economy has restructured itself over the last forty years to take advantage of the reduced transaction costs offered by the EU. They will struggle to adapt to increased transaction costs. That is why leaving will be so damaging and no-deal will be a disaster. We are trying to take forty years of efficiency gains out of the system that have been paid for with added complexity.

    The real difference between active and passive is in strategy. In investing we know we are gambling (well particularly in equities). Over time there has traditionally been a yield from total equities, but we don’t know who will be generating that return in the future, and there is volatility and all sorts of other things going on. We are placing a bet on what we think will happen.

    I think of the market as a casino which instead of taking a house percentage over time, pays out a modest gamblers percentage over time. Active investing is like betting on a single number on a roulette wheel. Most bets will lose, but when one pays out it pays out big.

    Passive investing is like betting black or red, odd or even. Your chances are better but your winnings more modest. You trade off the low probability big win for a modest regular win. We talk about risk tolerance, but ultimately it is just “Do I feel lucky?” “Well, do ya, punk?”.

    For me, once you have bought the diversification argument, you are inexorably led towards index investment (to efficiently get at diversification), and if you are a reluctant gambler to passive investment (as there is no point in churning investments, you just incur cost).

  • 29 ZXSpectrum48k May 25, 2019, 1:20 pm

    I’ve watched the rise of passive investing in EM bond markets for 20 years. For most of that period it was a positive but in recent years it’s started to create some deleterious side effects. It’s definately one factor (but not the only one or even the most dominant) that has distorted some bond markets.

    Passive investing tends to cause trending price momentum and repressed volatility on the way up given the self-reinforcing nature of the feedback loop between ETF returns and inflows. Price and yield levels become detached from fundamentals. When the shock then occurs, you get a cascade failure causing massive volatility; an airpocket or flash crash. The liquidity required in the ETF is often vastly larger than the underlying liquidity in the individual bonds.

    Passive investing is also starting to make EM bond markets less efficient and more exploitable by bond issuers. It allows sovereign/corporate issuers to undermine the “carrot and stick” relationship with the market. Issuers’ size their new bond issues to trigger optimal amounts of passive buying from index exclusion. The execute switch auctions to force passive funds to sell old bonds low and buy new bonds high. Active managers pre-position to exploit this. It’s made it easier for some EM countries to run terrible economic policies yet still rollover their debt liabilities. Fundamentals do finally catch up with them but it takes longer when passive investors remain forced buyers as the debt builds up. Fear of passive bond outflows has even impacted the ability of South Africa to challenge the impact of state capture and corruption.

    Finally, lower fees are a good thing for investors, but only when that doesn’t add risk. Many index trackers seem to have gone past the sweet spot. Using excessive amounts of bond lending, incurring significant credit risk, using lower quality bond custodians, all to reduce fees by 5-10bp is just not a good risk-return proposition for investors.

  • 30 Naeclue May 25, 2019, 1:59 pm

    @old_eyes, I agree with your active v. passive comment. Any fund not using cap weighting is an active fund as far as I am concerned, irrespective of whether a computer or human is involved in stock selection and weighting.

  • 31 The Investor May 25, 2019, 2:24 pm

    Great comments! Just briefly on the governance issue. Is there not a case for saying a passive fund could (should?) ultimately be a more engaged owner?

    An active investor can always sell and move on if they don’t agree with management or a board. In fact that’s often what they’re told to do in not so many words in contentious situations.

    A tracker manager does not have that option.

    The word passive (which as I’ve said before I don’t really like) comes with connotations but I think in investing it just means accepting the market’s pricing/weighting decisions. Don’t think it has to mean passive observer!

    There may be political/similar issues with Vanguard throwing its weight around but I wouldn’t have said the passive nature of fund strategy is a concern?

  • 32 Vanguardfan May 25, 2019, 3:09 pm

    Regarding pension funds being obliged to invest actively – I don’t understand this comment. All of my spouse’s occupational DC schemes have had good passive options, and furthermore the default option usually also consists of tracker funds. So clearly there is no requirement for pensions to be actively invested?

  • 33 MrOptimistic May 25, 2019, 3:52 pm

    I had a discussion somewhere else as to whether market capitalisation trackers had an in built momentum factor. Persuasive answer was no. On pension schemes, liability matching has certainly distorted the UK gilt market. More generally, I wonder if wealth creation relies on productivity gains and there isn’t enough if this outside of China. Certainly informal times low interest rates/ low cost of money implies too much capital chasing too few opportunities with some catastrophe finally causing capital loss. In retrospect, it will all be too clear!

  • 34 ZXSpectrum48k May 25, 2019, 4:40 pm

    I don’t understand the comments about charitable trusts or pension funds being obliged to invest in active funds. I’d also say that this idea that charities or pension funds should go passive seems to miss the point entirely. The key is that they meet or exceed their liabilities; how they best achieve that depends on the liability structure. Passive may be the correct approach or it may not.

    As an example look at the UK’s biggest charitable endowment, the £26bn Wellcome trust (https://wellcome.ac.uk/about-us/investments). I know their investment team well. Annualized returns of 14%/annum since the mid 80s with return volatility now at around 5%. If they have almost 50% invested in hedge funds and private equity, it is because they believe those funds suits their liability model. The idea that they are “forced” to use advisers is a nonsense. They do what they damn well want and they do it incredibly well. They are nobody’s fools.

  • 35 The Details Man May 25, 2019, 7:07 pm

    I’ll try to cover a lot in comment, sorry if I oversimplify things.

    The issue with pension schemes is that the trustees have a legal obligation to get investment advice when making investment decisions. For smaller pension schemes (less than a few billion), the easiest way is to hire an investment consultant. Now they are unlikely to advocate a low cost passive based approach. As Mrs YFG says: “investment consultant turkeys don’t vote for Christmas”. It is a big push to ask trustees to ignore or act against their investment advisors.

    The larger schemes will have investment teams dedicated to strategy, manager selection and investment management. But many still need to outsource elements due to regulations. The largest schemes will create FCA regulated subsidiaries that can provide regulated advice to the trustees. Likewise the largest DB and trust based schemes can register as an Occupational Pension Scheme (OPS) with the FCA. This means they can make day to day investment management decisions (using derivatives, tactical asset allocation etc).

    The big master trust schemes follow a passive low cost investment approach. Given they charge a c. 0.3% AMC there is little scope for active management. That said, they do use active managers when it makes sense. For example, NEST uses active management for some of it’s fixed income allocation (see ZX’s comment above).

    The DC default funds will have been designed with an investment adviser (external or otherwise) to create a suitable investment vehicle for the defaulted savers to build towards an annuity. These are usually a basket of passive funds so as to stay under the cost cap of 0.75pc. The quality of default options used to be very variable. But the rise of the master trusts and more transparency has really improved the defaults.

    Closed DB schemes also use active strategies. That’s because they typically use Liability Driven Investment. In short, they use bonds to match the future liabilities of their members retiring. They do this because due to being closed they do not have the benefit of new contributions from accruing members.

  • 36 Windinthefens May 25, 2019, 7:27 pm

    @IanH Financial advisers usually say “average” returns when they mean market returns- it’s a completely different thing! I’m not happy to accept average returns- that’s why I go passive!
    In relation to it whether there can be too much passive money, I suspect there will be an equilibrium point before 100% passive where active genuinely can find a bit of advantage. If and when that happens, I am confident we’ll all hear about it!

  • 37 Richard May 26, 2019, 6:51 am

    I think even those who invest in tracker funds are often still active investors. If they buy say a single global index tracker that is weighted accurately to the global index then perhaps they are passive. But many model portfolios I see are built up of a number of passive funds. This requires some active decisions. For example, having a home market bias to off-set currency risk, having a small cap or emerging market that that may still be a passive tracker but as a % of the portfolio reflects an active decision to weigh towards higher risk assets. The weighting of say bonds, property, gold etc. Even Monevators slow and steady looks active in this regard. So we become the active manager, we just work at a higher level than a fund manager (not looking at individual stocks).

    Then as @John says buying and selling is not passive. Most ‘passive’ investors are likely to drip into the market but will then sell large chunks as they come out to fund retirement, shift allocations to bonds etc. Plus fear, optimism etc all work to pull the ‘passive’ investor off-course and get them making ever more active decisions.

  • 38 Karthik Suresh May 26, 2019, 7:13 am

    The FT argument is probably as spurious as the rest because it assumes that returns in markets emerge from the “hard decisions” of active investors. However, the real reason valuations rise is because the underlying companies become more valuable – it’s the change in their business operations that eventually feeds through into earnings and valuations. Having a passive portfolio is just like having a passive share of a growing business, which will grow in line with the growth of the business. There is no need for active investors in that scenario – and if the entire market were dominated by passive funds, you’d get a return that was based more closely on the growth of the underlying companies – which is probably no bad thing.

  • 39 Father Dougal May 26, 2019, 8:00 am

    “Great comments! Just briefly on the governance issue. Is there not a case for saying a passive fund could (should?) ultimately be a more engaged owner?”

    Spot on. There are examples where shareholder pressure has put the brakes on cockamamie schemes like the Unilever board’s idea to delist in London (as a transparent attempt to hide behind Dutch legal protection from takeovers). In the past, I think the passive managers have been quite hands-off, letting their votes at AGMs default to the management-recommended option (so, by default giving the nod to approval of whopping and unjustified directors’ remuneration).

    It would be great to see Vanguard and the others devoting more resources to standing up for the interests of the humble shareholder. But I wonder how compatible that is with a 5 basis points management fee when the ETF owns thousands of companies. (That’s not to say that the active managers have a great record on this either, though.)

  • 40 The Borderer May 26, 2019, 9:18 am

    @Vanguardfan(32)
    My own (vicarious) experience regarding large quasi public investment was not in relation to pension funds, but investment of capital. So there was no legal requirement to invest using active funds. Rather, it was board pressure on university officers aka “do you mean to tell us that you know better than Messrs Takem, Forwhat and Worth in the university’s investment strategy?”.

    I imagine that this is all to common in public institutions and NGOs. What finance officer would put their head above that parapet?

  • 41 Mikael May 26, 2019, 10:42 am

    Great post! Made me think about passive funds vs active investors. Perhaps price discovery can happen even if used funds are 100% passive? Investors still behave actively, and the various overlapping but not completely matching funds/ETFs they have will set the prices.

  • 42 Matthew May 26, 2019, 10:57 am

    @richard – you could argue that the only passive allocation would be the same ratio of stock:bonds as the world – is if global bond market approx 100tn and global stock market 64tn then we should hold approx 1.5*more bonds than stocks, ie 67:33ish. Allocating according to risk tolerance is an active decision, for the same reasons as tilting towards small/emerging would be

  • 43 Ben (other) May 26, 2019, 12:03 pm

    @Mathew

    I suppose if you follow that logic, you need X % in land, X % in bitcoin, X % under the mattress? You can construct a fairly good argument that putting money under the mattress doesn’t meet your aims, and I suppose that’s the point. You use past performance as a guide to invest in likely assets, but it isn’t guaranteed, there are risks, you just have to work within your own risk tolerances.

    I’m not sure the point of the exercise is to replicate anything, that’s a means to an end. If you’re merely trying to precisely match how the world invests you’re missing the point. Its about trying to maximise wealth, with risk, and risk tolerance being important inputs.

  • 44 A Betta investor May 26, 2019, 12:12 pm

    I think Mr Monevator just made the case for smart beta.
    No passive fund is truly passive, there are always decisions to be made because of corporate actions of fund flows. But if a fund is rules based and not subject to the whim of an individual then it can be run at low cost and low turnover.
    How it is weighted is a secondary argument and in time I think mkt cap weighting will be seen as a big mistake. Using a fundamental, non share price linked measure removes the need for active funds to “discover “ prices.

  • 45 Tyro May 26, 2019, 12:17 pm

    In this debate there’s some elision around the referent that the descriptor ‘passive’ applies to. It makes most sense to me to think of it as referring to the fund, not the investor, and I go with TI’s distinction (algo vs human). That way, we can see that there might be active investors of passive funds (e.g many of we Monevatorites), and also passive investors of active funds (e.g. those people that have no idea what their pension is invested in – probably a very large proportion of the population).

  • 46 ZXSpectrum48k May 26, 2019, 12:21 pm

    I don’t really understand why some people see market capitalization as the pure “neutral” or “passive” position. From my perspective, the neutral position is what best hedges my liabilities and there is no reason for that to be a function of market cap.

    In bond markets, it’s silly to weight your portfolio by market cap. Vast proportions of the corporate bond market are not at all liquid and held essentially privately. Large segments of the govt bond markets are held by non-economic agents such as central banks and reserve managers and never see the light of day. Do you really want your passive fund to buy more debt from Argentina and Venezuela just because they decide to issue to stave off collapse? Nearly all institutional managers use capped and liquidity-adjusted (float adjusted) bond indices. Are they all wrong?

    Even on the equity side, the S&P500 is market-cap weighted, but float-adjusted. How will indices adapt as quoted equity markets shrink and private equity rises (which is what is actually happening)? Look some recent tech IPOs. The private equity investors decide they have extracted all the value from a new tech company. What do they do? They use the IPO to exit at a premium price in the sure knowledge that there is a guaranteed bid from large passive funds who need to buy for index inclusion.

    I think there is great danger is assuming that that indices are “the market”. I’ve managed the process of building some very widely used bond indices and they are always somewhat subjective in their construction.

  • 47 Matthew May 26, 2019, 2:30 pm

    @other Ben – we could be saying that we consider a pound allocated to stocks/bonds to be smarter than a pound in bitcoin or under the mattress – but like you say our own life objectives are a valid reason to diverge, so I put it to everyone that if we can diverge between one asset sector and another it is reasonable to diverge within the sector. The fact that life needs force divergence also means that within the stock market not everything would be priced by one method – ie it might have more large cap than its risk adjusted return would justify just because so many people like safety and ease, and liquidity.

    By the way, it’d be possible to have funds for all these things, even cars, art, etc, but actually discovering market caps might be tricky. We could assume that the stock market as a whole largely represents everything, though maybe not in the right amounts

  • 48 Ben (other) May 26, 2019, 3:31 pm

    @Matthew

    I assume by ‘diverge’ you mean active investing.

    Well yes. I don’t passively invest because there is something morally or religiously good about it. I invest passively because the stats say that after fees I will do better than investing actively.

    If a Mr B Jogle popped up with evidence that active investing was better than passive, I would put my money in Ganvard ™.

    I don’t think theres anything in ‘the rules’ preventing taking a view on something and acting appropriately. The act of investing itself (even passively) is taking a view (that the world will be around in 5+ years). I have a view on the B word that shan’t be name named and adjusted my UK exposure accordingly, I have a view on the likelihood of the Nigerian Prince who just emailed me, actually being a Nigerian Prince. I don’t think I should be ignoring those views just because they aren’t passively pure.

  • 49 Tedious pseudonym May 27, 2019, 4:09 pm

    TL;DR – index investing is a short hand for passive investing, but if they become an excessive portion of the market, they are no longer able to operate to provide average market returns (which isn’t inherently the index, crucially).

    There is a problem though in all the passive investing; that in short, it’s not actually practically possible in the manner that is implied by the “zero sum” argument, because the reality isn’t quite what is stated by the “rule” – and the larger, proportionately, index investing becomes, the more of an issue this becomes.

    This isn’t, BTW, an “oh active investing rocks” post – it’s just that passive investing _is_ active and people are pretending it’s possible to buy “an index” when it absolutely isn’t.

    What is _actually_ mathematically the case is that for any pound received by an investor that is greater than the _market average_ return, then another investor must have received less than the _market average_ return. You then construe the index _as_ the market average, and this is largely the case – but an index _fund_ is not, because it _has to trade_ to be able to follow the index, and this is where our problems lie.

    In a very large market with substantial liquidity and proportionately fairly small indexes, this is moot because there is enough liquidity for a fund to buy and sell as it takes money in and has to settle redemptions.

    Envisage, however, the potentially forthcoming Aramco float – which while exceptional, isn’t unique – a very large, but very close company – think most of the large tech companies as well. They are intending to float just 5% of their shares, but with a $2 _TRILLION_ dollar market cap. Yowsers. Imagine this happened in London. If the index is to genuinely represent the market, then Aramco would be bigger in aggregate than the bottom 85 companies of the FTSE 100. Since only 5% is liquid, it would be impossible for people to buy enough shares to give it sufficient weight, as they’re simply not available.

    The answer to this is to manipulate the index by weighting companies by liquid float – IIRC there was something of this when Glencore floated and only had a bit over 10% sold to the market. The index, however, then does not in fact represent the average of the market, so it is perfectly _mathematically_ possible for every active investor to beat every index investor – because they can potentially buy things that aren’t counted in the index for reasons of being able to make it work.

    So, in summary, very low cost, algo traded funds are almost certainly the way forwards – but index trackers will ultimately fail to be able to track the index, or the index will fail to track the average of market returns, which is the same thing said slightly differently, and thus you can’t just passively invest and forget forever.

  • 50 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!

  • 51 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.

  • 52 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.

  • 53 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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