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The Myth Behind Passive Investing

 

It is common for investors who have suffered losses in their portfolios to hear generic responses on how to proceed or how to put their loss into perspective.  Whether intentional or unintentional, the inevitable goal of those dispensing such advice is to deflect blame to factors that are out of anyone’s control – like dropping stock markets which, arguably, could not be foreseen.  What are these canned responses that are being referred to?  Well, here are some of the more common ones:  “Don’t worry, you are a long-term investor, your wealth will come back”, “We can use this to average down your investment costs”, “Stay fully invested at all times, history has shown that this works”.  Unfortunately, if repeated enough times people begin to believe in things that might not serve them well.  Yet more often than not, such statements provide only temporary solace to an investor that has suffered significant wealth destruction and is now set years back from achieving their financial goals.

Why do investors hear these statements from their advisors?  A commonly held belief is that passive investing (investing without dynamic shifts between asset classes) is a proven long term strategy.  Although passive investing is a theoretically sound investment strategy which in and of itself does not imply negligence by an advisor, the advocates for such strategies are often those with a vested interest in applying it.   This includes the mutual fund industry and the advisors that use their products.   To understand how, it is important to recognize that many financial advisors receive “trailers” or commissions for having clients invested in particular mutual funds. Therefore, shifts into lower fee or no fee asset classes can directly impact their level of compensation.   Some would argue that fixed income, money-market, or other non-equity asset class mutual funds exist and therefore any advisor who only employs mutual fund instruments still has the ability to rotate into varying asset classes without suffering a loss of generated commission dollars.  Unfortunately, advisors that heavily use mutual funds are often more familiar with the mutual fund products themselves, instead of being familiar with the market conditions that dictate when to make tactical or strategic shifts in asset mix.  In summary, from the advisors perspective, deciding to utilize a passive investment strategy is optimal since it can be defended as being a prudent strategy, it is fee generating, it requires less effort, and in some cases it is all that the advisor can provide to clients.

Why “active” mutual funds aren’t really active.    Although there are many different types of mutual funds, most are defined by some underlying index which is then tracked by the fund.   Even in the situation where a mutual fund is said to be “active”, the fund managers are often required to keep pace with an underlying benchmark and are restricted from having their fund deviate significantly in its composition from that of the benchmark.  This includes restrictions on the proportion of cash holdings that the fund can maintain for the purposes of capital protection.  The results of all of this can be seen in the chart below, which displays the returns for the average and median Canadian equity mutual funds along with the return of the S&P TSX index.  Not only did the average Canadian equity mutual fund not protect its holders from downswings in the underlying index, but it actually performed worse in every time period than the benchmark that it was attempting to track.

 
 

 return-of-the-median-average-canadian-equity-mutual-fund

 

 

 

This result may seem upsetting for many fund holders.  But like the financial advisors that place their clients into these funds, the mutual fund managers aren’t being negligent either. This is because; from the perspective of the fund managers it is the investor’s advisor that has the responsibility of reducing holdings of higher risk investments for the purposes of capital protection.  As a result, the end investor becomes a potential victim of multiple layers of passive investment management.

What is the truth then?  Before continuing, we will acknowledge that there will come a time when the wisest course of action that we can undertake for our clients is to deploy their wealth into market instruments and stand on guard for the investment climate to change.  Fortunately, we chose not to test the merits of passive investing during the recent sell-off, opting instead to rotate into the safety of cash.  The recent sell off in equity markets is an important reminder of the potential harm that can come about from passively standing by during times of upheaval.  The long term performance results of passive investing, highlighted below, speak for themselves.

Without attempting to demonize advisors or industry attitudes we simply note the following undisputable facts.  Firstly, and not surprisingly, neither the S&P 500 (US) nor the S&P TSX (Canada) have made any price gains this decade.  In other words, a dollar of cash invested in either price index made no meaningful returns over the last decade, as seen in the chart below.

 

 Source StockCharts.com  

 sp500-and-sptsx-price-gains2

 

 

 

Furthermore, the US S&P 500 equity Index (an index consisting of the largest 500 companies in the US) has performed no-better than US government bonds over the past 40 years.  (Source: BCA – special report 20090201)  To understand why this is important, recognize that US government bonds are considered to be a very safe asset and should, in theory, have a much lower return than equities due to the risk-reward trade off.  Therefore, a passive 40 year investment strategy in the relatively risky S&P500 only produced returns that were comparable to that of relatively safe US government bonds.

But what is most shocking is that during the past 12 years, cash returns in the US have done just as well as US stocks (Source: BCA – special report 20090201).  Essentially, passively investing in the market got you nowhere during this period.  Now having seen this, I’d like to return to something that was noted earlier, which is the commonly voiced statement by advisors in situations like these: “Don’t worry, you are a long-term investor”.  To which the counter question should be posed, “twelve years isn’t long-term?”. 

Finally, if you are feeling as if you should give up and begin hoarding cash, gold, and clean water; then we would like to leave you with the following chart by BCA Research.  The chart shows the one year returns of the S&P 500 over the last century.   Note, that for almost 25% of the periods shown the S&P 500 returned over 20%. As well, for almost 70% of the periods the S&P 500 made positive gains. 

Therefore, by actively attempting to capture the gains of the S&P500 and mitigating the losses, an investor can potentially be rewarded handsomely.   Some advisors may say, “yes, but that is difficult to do”.  In which case, you may wish to remind them of what they are being paid to do.

 

 

 

 

  

century-of-stock-market-performance

The preceding entry is intended for general educational purposes only and should not be construed as financial advice nor is this information intended to replace the advice of a licensed financial advisor.  All readers are encouraged to review their personal financial situations and needs with a licensed financial advisor prior to making any investment decision.  Although efforts have been made to validate the information presented in the above entry, Pacifica Partners Inc. can accept no responsibility or liability as to the completeness or accuracy of the information contained above.

 

 

 



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