Passive Investing WILL NOT WORK in The Next Decade

Passive investments and the power of compound interest have been touted as the holy grail of investing. While this method of investing is supported by the last 50 or so years of market data, peddlers of this method often forget a key statement from SEC regulation:

A fund’s past performance does not necessarily predict future results.

While this phrase is thrown in the face of active fund managers, passive investment proponents seem to forget it when evaluating their own arguments. The main statistic that is often cited by passive, indexed fund proponents is the fact that an S&P index fund has outperformed most active managers over the past 30 years. However, in light of massive shifts in market conditions, this argument needs to be reevaluated. Just because the passive approach has worked in the past does not necessarily mean it will work in the future — especially in an economy that is levered to the hilt and facing slowing global growth.

Index Funds Outperforming Actively Managed Funds.

The argument that a passive, low fee index fund (comparable to buying 1 share of every stock in the market) would have outperformed the average of actively managed funds (which shift money between different stocks, hoping to outperform the index) over the past 30 years is undisputed. This result is largely due to the fact that although actively managed funds charge higher fees, they rarely outperform the market enough to make up for the fees. However, hedge funds, which make up a small minority of the funds being considered, have produced some outstanding results over the past 30 years. The major difference between hedge funds and mutual funds is that a mutual fund can only put its money to work by buying equities and bonds. They cannot utilize options, sell short, trade currency or commodities in a combined, hedged fashion (they can trade individually. Meanwhile, a hedge fund can go to any market in the world and go long or short. Clearly clumping together the results of these two very different types of managed funds makes no sense. Looking at the results of an index fund versus hedge funds, the hedge funds largely outperformed the market over the past 30 years.

Changing the Assumption of Inflation

So what is going to change this dynamic and cause index funds to lose their low cost, average return appeal? Deflation. Deflationary cycles only come about once every 80–100 years — longer than most human lifetimes. The last time the US experienced a sustained period of deflation was during the Great Depression, which is not during the lifetime of most people who are alive today. Because it has been so long since the last wave of deflation, most people have come to assume that a generally upward long term trend in economic growth is the norm. Normally, growth on a large scale is driven by expansion in credit which leads to greater economic productivity on a shorter timeline. However, the growth of credit makes necessary a slowing period when earnings have to be used to repay that credit. On a massive scale, this occurs in 100 years waves with long sustained periods of growth followed by short, sharp periods of credit contraction. During credit contraction, either debts are repaid or borrowers go into default. Either way, total debt decreases. This unburdening of debt allows the cycle to start anew.

The long steady growth of credit over the last 80–90 years has led to steady, reliable inflation that has caused all asset prices to rise alongside increased economic productivity. However, investors today cannot allow recency bias to cloud their evaluation of where the market is headed. The next deflationary period is likely beginning now judging by falling productivity, slowdowns in lending, and very low inflation numbers worldwide. Once this deflationary trend takes hold, there will be a significant decrease in asset prices that they will not recover from for 20–30 yards based on past examples. During the period from 1915–1950 asset prices effectively went nowhere.

What to do About it

Relying on steadily increasing asset prices while paying no mind to significant changes in market conditions is a recipe for disaster. The only option that retail investors have (assuming they do not have the funds to access a hedge fund manager) is to become better educated in investing. The most common response to this statement is “I don’t have time” closely followed by “I don’t want to spend every minute checking a stock ticker.”

In response to the assertion that average retail investors do not have time to educate themselves in finance, the only response is to call them on their bold faced lie. In the words of Gary Vaynerchuk “Stop watching f***ing House of Cards!” In the era of open courseware, YouTube tutorials, and endless financial bloggers (myself included), the only way someone doesn’t have time is if they don’t make time.

To the person who is worried that they will have to check a stock ticker every second: day trading is not the method being advocated here. The method is event-based investing, taking in the macroeconomic landscape, and acting on that information in the most prudent way possible. This method requires being open-minded to risks that may not be intuitive and hedging against them once they become apparent. Realistically, it means taking 2–3 hours a week to deep dive into what has transpired during the previous week and how it affects your assets.

Happily Ever After

Although the evidence is pointing towards a sustained period of deflation worldwide, there is a positive point to be made: The world will be on sale! Every valuable asset will be for sale at unimaginably low prices. In the event that retail investors can hedge appropriately and retain a significant level of cash or highly liquid assets, they will be able to make investments that will make them very wealthy. Those who take charge of their investments now and toss aside the passive investment narrative will undoubtedly reap the rewards over the coming decades. Remember to hedge!

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