Active vs Passive Investing: Is Ignorance Bliss?

“Active investing” is an investment strategy where investment decisions are based on independent assessments of each investment’s worth—essentially, trying to choose the most attractive investments. Generally speaking, the goal of active managers is to “beat the market,” or outperform certain standard benchmarks. For example, if you’re an active investor, your goal may be to achieve better returns than the S&P 500.

If you are a passive investor, you would not undergo the process of assessing the virtue of any specific investment. Your goal would be to match the performance of certain market indices rather than trying to outperform them. Passive managers typically seek to own all the stocks in a given market index, in the proportion they are held in that index. Because active investing is generally more expensive (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), many active managers fail to beat the index after accounting for expenses—in those cases, passive investing may have outperformed because of its lower fees and costs.

Today, if you check any S&P 500 company to see who owns the most shares, there is a good chance that Vanguard or Blackrock is one of the top holders.

This is largely thanks to the financial innovation of John Bogle, the founder of Vanguard who thought that the average Joe was paying too much for investment counsel when simple exposure to American industry at large would do just fine for your everyday investor.

Lower fees as a value proposition is easy to understand. But there is no such thing as a free lunch:

According to an article published in Forbes, Mr. Bogle pointed out that as indexing increases to a certain point it opens opportunities for active investors to exploit inefficiencies in the pricing of some stocks. However, past that point, wherever it might be — somewhere beyond 75%, in his view — the market could become a dangerous place. Trading would dry up if only indexers comprised the stock market and there were no active investors setting prices on individual issues.

“If everybody indexed, the only word you could use is chaos, catastrophe,” Bogle told Yahoo! Finance at the Berkshire Hathaway annual meeting. “The markets would fail,” he added.

Why would this be dangerous? Perhaps it’s time for a refresher on the role of active management.

An active investor’s job is to make money for their clients. But together as a group, they take on a special role.

Active Investors set the prices for capital across the global economy. This is not limited to stocks and bonds either. George Soros is famous for ending an unsustainable situation when he “Broke the Bank of England”.

The collective decision of many to pursue the passive investing route has allowed Larry Fink, the founder of Blackrock, to hold some pretty serious sway in corporate board rooms across America.

Mr. Fink famously began writing annual letters to American CEOs in the wake of the 2008 financial crisis. This makes sense. If the average investor doesn’t have the expertise to be active, it makes sense to offload the responsibility to someone better suited for that job.

However, the scale of responsibility falling on one or two firms could be problematic. Historically, such concentrations of power over a nation’s economy fell upon government officials, which were not generally handled in a capitalistic or market-efficient way.

Proponents of passive investing would say: So far, so good. For the most part, stock markets have gone up since this broader movement began in 1974 with the founding of Vanguard.

But the market has had its rough patches. Investors who needed money to fund their retirement in between 2000 and 2010 were in for a bumpy ride, as shown below.

SPX (S&P 500) Index

Markets have prospered since that rough period, but some investors point to the huge decline in interest rates since 1980 as responsible for the bulk of return on all assets. By definition, when a bond has a lower interest rate than when first issued, its price goes up.

Per the 10-year treasury bond shown below, rates cannot go much lower, meaning this tailwind to passive investors could be disappearing.

10-Year Yield (USGG10YR Index)

But the flows to passive investing continue unabated. Logica Capital writes:

“Today, more than 100% of gross flows into the stock market are passive (meaning discretionary managers are facing gross redemptions), and nearly 85 cents of every incremental retirement dollar now flow into a target date fund. Roughly half of all 401Ks hold a target date fund as their sole security.”

The firm also notes that Vanguard and Blackrock heavily influence the regulatory environment.

5-Year Cumulative Active Vs Passive Flows

But what are target date funds? A target date fund is based on a target retirement date for a given investor. The fund chooses an appropriate allocation between stocks and bonds based on a said target. So, as investors near retirement, the fund rebalances towards more bonds.

Remember those meager interest rates shown above? That may be the tip of the iceberg, as rates in numerous countries have gone negative. Charted below are the dollar amount of negative trading bonds globally, denominated in millions, which shows that at its peak there were over $18 trillion of negative yielding bonds.

Barclays Global Aggregate Negative Yielding Debt Market Value USD (BNYDMVU Index)

While Vanguard wrote an article defending the purchase of negative yielding bonds, the massive fund manager may be forced to play this hand. Indeed, when you are as large as Vanguard and your mandate is to invest passively, you are required to own negative-yielding debt, thus the need to extol its virtues. Active investors, on the other hand, have the flexibility not to own these negative yielding instruments.

As mentioned earlier, the consequences of Vanguard getting too big were not unforeseen by its founder, John Bogle. Without active managers to make prudent decisions, some careless ones are likely being made as well.

In his article for the Financial Times, Theory of (Almost) Everything for Financial Markets, Robin Wigglesworth comes away unworried about the pernicious effects that passive investing has on markets. He notes that passive investors invest 100% of cash received while active investors often hold a cash buffer. Logica Capital notes this as a reason for higher valuations, though Mr. Wigglesworth is unconvinced, stating low (and even negative) rates and highly oligopolistic companies are also reasons for higher overall valuations in the market today.

While he’s not concerned, it is interesting to note that traders front-ran Tesla being added to the S&P.

The stock has been treading water since being officially added in December, 2020. As a result, active managers who bought Tesla prior to its inclusion in the index have enjoyed significant gains, while passive investors only were able to buy in to the company after the large run up in price. This could be a unique case, but many commentators have taken note.

History of TSLA

Conversely, the Dow Industrial Average dumped Exxon recently as well. While the stock struggled initially after it was booted from this index on August 31, 2020, it is up overall since.

While electric cars may be all the rage and fossil fuels are looked down upon, there are still countless vehicles with internal combustion engines on the road, airplanes in the sky, and other uses for fossil fuels. Letters from Mr. Fink from Blackrock won’t change those facts.

If the future looks like the past, then passive management is positioned to do well. But as the well-known disclaimer on all financial products states, “…past performance is not indicative of future results.”

“Stocks only go up!” said Dave Portnoy, of Barstool Sports fame, amid a global pandemic. Clearly, Mr. Portnoy was not trading in 2000 or 2008.

While there is no clear answer to which strategy is preferred in any given climate, suitability will always depend on an individual investor’s particular financial situation, knowledge and experience, investment objective and horizon, or risk profile and preferences, which should be determined with the consultation of one’s financial advisor.

With negative yielding bonds making way into indices, maybe it’s time to look at what you own?