Passive investing… or active investment management?

Index buying, or passive management, means portfolios mirror the components of a market index. It is the opposite of active management where a fund’s manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities.

Index buying, has enjoyed a period of prolonged growth since the mid-1970s when Vanguard, the world’s leading passive investment management company, launched its first mutual fund. According to a recent report by the New York Times, Vanguard has attracted a total of $823 billion of new investment in the past three years and now receives $2 billion per day. This is 20 times the level it received in 2009. Vanguard now has close to $6 trillion funds under management, currently owns 6.8 percent of the US Stock Market and has more than a five percent stake in 491 American companies.

Overall, the total amount now invested in passive funds in the US is within touching distance of the amount invested in active funds. 2017 could possibly be the year in which passive funds overtake active funds in US assets under management.

But what does this mean?

Active investment managers reduce risk by selling into higher prices, passive investing ignores such rationality. Investors are increasingly seduced into blindly allocating capital according to market capitalisation, rather than by means of price and value. Index buying has a history of being in vogue at stock market peaks. It has a tendency to be pro-cyclical, exaggerating market moves. Being momentum driven means, buying leads to more buying.

According to a recent report by JP Morgan, 40 percent of daily New York Stock Exchange traded share volumes take place in the last hour of trading, as passive index funds rebalance their portfolio weightings. This is investment by conditioned reflex, which frequently leads to indices moving from negative to positive territory.

What happens when the robot controlled machines are programmed to sell? Will they be just as price and value insensitive on the way down as they were on the way up? Quite probably.

What are the consequences?

At Clarion, we favour active investment management over passive investing, yet we do not deny that there is a time to ‘buy the market’ via the purchase of an index. Some of our favoured active managers have done just that at stock market bottoms in 2003 and 2008 as, at such times, it is usually the most distressed equities that bounce back the hardest. Active managers are able, therefore, to benefit from holding shares that they may not wish to purchase individually by buying the index.

With stock markets close to all-time highs, it is also worth remembering that not every market cycle is the same, and markets might drift in a trading range for an extended period of time. In this scenario, it is quite possible that there will be a wide divergence between the winners and the losers and traditional stock-picking will once again come to the fore. Sideways markets, where stocks are experiencing neither an uptrend nor a downtrend, are a good time to be picking quality stocks and a miserable time to be locked into a passive fund going nowhere.

Long term investors look for more than just benchmark-beating returns. They want outcomes or solutions such as sustainable income, risk management, capital preservation, and controlled investing with the ability to pick tomorrow’s winners. The best active fund managers selected by Clarion focus on delivering such outcomes. In our opinion, the very best active managers are certainly worth paying for and well worth the extra cost compared to an index tracker.


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