The benefits and risks of passive investing
The popularity of passive funds is growing, attracting investors with the promise of dramatically lower costs than actively managed alternatives.
What are passive funds?
Passive funds track the performance of a particular market or index, such as the FTSE 100. As well as unit trusts or open-ended investment companies (OEICs), passive funds can also be stock market listed exchange traded funds (ETFs). What they all have in common is that they typically hold all the assets in the index they’re tracking, or a representative sample.
Crucially, most passive funds are operated automatically rather than by a fund manager, which dramatically reduces their running costs.
Much of the debate between active and passive strategies comes down to this issue. Essentially, whether it’s worth paying the higher costs levied by active fund managers or whether you’re more likely to enjoy greater rewards in the long run by sticking to cheaper passive vehicles.
One of our principles of investing is that you should only move away from passive investments if you have good reason and fully understand the total cost incurred.
What's the difference in terms of costs?
In many cases, investors pay annual charges of around 0.75% a year for actively managed funds. In contrast, some passive funds charge less than 0.1% a year.
When you are a passive buyer/seller you take (as you have no choice) the prevailing market price at that exact moment that your capital hits the underlying market.
Robotic passive buyers are price agnostic, price takers rather than setters.
The market capitalization of the underlying Investment is the only variable considered. This is why the ever so mega big companies keep getting so much bigger.
This has resulted in many (if not all) historical evaluation measures presently not just looking eye watering, but at unprecedentedly nosebleed levels.
How long this will continue (and can go on for) until the inevitable tipping point is flipped, it is impossible to say.
Like all unsustainable manipulations, it will end one day. History suggests very quickly and with little warning.
This tipping point will be when passive selling is in the majority, a structural and dynamic change in a markets composition.
Those required future buyers will then use valuation and price discovery as entry points for their capital to be placed into markets.
This change will see a violent snap back to valuation fundamentals, at prices significantly below the levels that the passive investors had expected and got used to.
This is why Michael Burry of The Big Short, just walked away, just like he did before.
His final investor letter contained one sentence that should terrify every fund manager, Central Banker, and policymaker on Earth: “My estimation of value in securities is not now, and has not been for some time, in sync with the markets.”
Passive index funds now control 52% of all U.S. fund assets. Fifteen point four trillion dollars. BlackRock, Vanguard, and State Street collectively manage twenty five trillion. They own dominant stakes in virtually every public company in America.
They analyze nothing.
Every dollar flowing into an S&P 500 ETF automatically allocates thirty five cents to seven stocks. Not because someone studied the balance sheets. Because that is their index weight. The algorithm cannot read an earnings report. The algorithm cannot process overvaluation. The algorithm simply replicates.
THE DEATH SPIRAL
Passive buying increases prices. Higher prices increase index weights. Higher weights attract more passive buying. The feedback loop operates completely independent of whether any business is worth what the market claims.
The marginal buyer of American equities is no longer an Investor with conviction.
It is a buyer who has no opinion.
Price discovery, the mechanism that has allocated capital for two centuries, has been structurally disabled for some time.
We do not know when the exact tipping point flips and the baton of pricing is passed from passive investors into the hands of the active investor.
With hindsight we will all know.
