Active vs. Passive Investing

[Dexter]

This topic has been in the news recently, and I think it merits some discussion.

Since 2005, net flows of U.S. stock mutual and exchange-traded funds have been positive for passively managed funds and negative for actively managed funds.  The WSJ has some interest charts on why investors are choosing to go passive versus active.

http://www.wsj.com/graphics/passive-investing-five-charts/

Essentially, this article argues that: 1) over the last 25 years the majority of U.S. large-company mutual funds have underperformed the Vanguard 500 Index Fund, 2) annual fees for actively managed U.S. stock mutual funds are almost 7 times higher than those for passively managed funds, 3) of the 20 best actively managed U.S. stock funds for 10-year returns as of 2005, only 7 were better than the average over the next 10 years, and 4) Morningstar Domestic Stock Fund Managers of the Year generally don't perform as well relative to the average in subsequent years.

All of this adds up to money flowing into passively managed funds.

This is an interesting dynamic, as passive investment is becoming a larger part of day to day investment flows.

Here's one interesting article about the shift from active to passive investment: https://www.bloomberg.com/view/articles/2016-10-28/shift-from-active-to-passive-investing-isn-t-what-it-seems

In this article, Bill Miller claims that many active managers are really just "high-priced closet indexers."  Miller believes that about 70 percent of all active managers are closet indexers -- i.e., their funds own many of the same stocks as the index (to avoid too much deviation from the index), but they charge higher fees for their active management 'skills.'  This is a toxic combination that leads to underperformance. 

Given the incentives of most investment managers (job preservation & maintaining AUM to keep collecting fees), it wouldn't surprise me if a large percentage of active managers really were just closet indexers. 

So, to some degree, it makes sense that we would see a shift from closet indexer "active managers" to passively managed funds. 

However, I think there could also be a performance chasing aspect associated with this shift.  More on this later....

[Dexter]

The data that's been coming out over the last year or so is strongly in favor of passive indexing.  Here's a recent FT article that makes a convincing case for investing passively:

https://www.ft.com/content/e139d940-977d-11e6-a1dc-bdf38d484582

These types of articles have been constantly popping up in the media.  The response from the public and financial fiduciaries has been to switch to passive strategies (market-cap type indexing).  On the face of it, this seems perfectly rational.  Why pay more for an active manager if that manager can't beat a low-cost index fund after fees?  (Answer: You shouldn't.)

However, whenever I hear that funds are consistently flowing into a specific strategy or asset class, it makes me wonder if the valuations in those areas are being stretched.  If they are, that could lead to some epic declines -- and I don't like losing money.

Another thought I have when I read these stories is: Could the fund flows be the cause of the outperformance?  In other words,  is there some reflexivity going on (i.e., a circular relationship between cause and effect)?  Could the heavy fund flows be increasing the prices of the underlying stocks in the indices, and thus enticing other people to invest in passive strategies, which then further drives prices up (and so on)? 

Now, I'm not saying that passive investing is in a bubble.  It is a popular strategy, but that doesn't mean there's not some good reasoning behind it.  And for all I know, this shift from active to passive could continue for quite a while.  (Frankly, I do think we have quite a few active managers that do not deserve their fees -- and should be fired.)

Ultimately, though, I think it comes down to valuation.  What are getting for your money?  This is the litmus test that investors should use. 

To be continued....

[Dexter]

Here's another perspective from Steven Bregman of Horizon Kinetics.

http://finance.yahoo.com/news/analyst-sounds-the-alarm-on-the-most-crowded-trade-in-investing-history-180954941.html

While Mr. Bregman notes that the idea of indexing is sound, he believes supply and demand issues are leading to distortions in asset prices.  In fact, he goes so far as to say: "The index universe has simply become a big momentum trade and it's the most crowded trade, we think, in the history of investing. And crowded trades eventually attract short-sellers. They just need a starting gun."   

In this article, Mr. Bregman raises some interesting points:

1) Index ETFs may not have as much underlying liquidity as expected if net-selling occurs.
2) Many index ETFs lack adequate diversification.
3) The "ETF Divide" (Horizon Kinetic's term for the division between securities that are included in an index and those that are not) is creating opportunities in neglected non-index securities.
4) The end of the index bubble phase could lead to a "golden age for the active value manager." 

This article definitely provides some food for thought.  When a large crowd starts investing in specific assets or securities, it usually makes sense to take a look around and figure out if other assets or securities are being overlooked and undervalued.   

[Dexter]

Some interesting points are made in this article about the challenges of active management.

http://www.advisorperspectives.com/articles/2016/12/21/new-evidence-that-challenges-active-management