Active Investing is Dead
Long live active investing.
This article was originally published on Seeking Alpha. Now that the company has released my content, I wanted to provide an updated discussion. It’s rather interesting. When I first published this article a little over two years ago, the stock market was doing great and everyone was riding the wave. Now the wave’s hit some jagged rocks, and even though 2018 saw a large outflow from active into passive, I do expect 2019 to see the reverse.
- Active investing has been on the decline, while money has been flowing into passive funds.
- It is easy to make a profit from the market, when everything is going up.
- Active investment makes more sense in a bear market.
- There is a risk of mass drawdowns.
- Motifs are alternatives to ETFs.
Thesis: Passive investment strategies make sense in a bull market, as everything is going up, and there are less overhead costs. However, as the market cycles into a bear market, stock picking will become more important again. Furthermore, as passive investment ETFs start under-performing as the market declines, there could be a substantial drawdown from some of these funds. An alternative would be to create your own “fund” using Motif Investing, which allows for both passive and active investing strategies.
Dale Roberts wrote an article on Wednesday about the shift from active to passive investing. He made some really good points. And his view is in line with Warren Buffett’s, which places him in good company. Also, (SPY) has been tracking the S&P 500 very well, having more than doubled over the past ten years. But I decided to write a rebuttal as (1) I feel that passive strategies have only given way to active strategies because the market has been burning so hot lately and (2) I could not pass up such a fun title.
It is true that, at least as of now, there has been a large shift in revenues between active and passive funds. Moody’s estimates that passive funds will overtake active funds, sometime between 2021 and 2024. It is also true that passive funds have significantly outperformed active funds over the past five years. It is also true that in 2016, inflows to passive funds totaled $504 billion while outflows from active funds totaled $340 billion. But we are also in the middle of the longest bull market in history.
Hartford Funds has an interesting white paper on the cyclical nature of active and passive fund performance.
From 2000 to 2009, active outperformed passive nine out of 10 times. During the decade before that, passive outperformed active seven out of 10 times. And over the course of the past 31 years, active outperformed 16 times, while passive outperformed 15 times.
Specifically, active investment seems to perform better in high dispersion markets. Given the incredibly low level of the VIX (VIXY), and the stock markets barreling full steam ahead, it makes sense that passive funds would outperform. Furthermore, it makes sense that passive funds would see a large inflow of funds, as passive investors keep trying to profit off of new all time highs.
However, as I mentioned in one of my end of the week wrap-ups, there has been evidence of a potential slowdown in stock growths. If that slowdown occurs, active managed funds will become more desirable again.
Update: Obviously the market has continued to grow slowly since the release of this article. However, there is still continued pressure which has prevented the kind of peak returns that we saw during the this bull market.
In “Market Sentiment Vs. Reality” I mentioned an indicator of when stocks will turn around: disposable income. When disposable income starts to drop, passive funds will start to see a slow down in inflows. As the decline in disposable income deepens, and as these funds start to underperform active funds, the inflows will turn to outflows. Some of the larger funds should be fine, but a lot of the new ETFs are small, and subject to depletion. Now, banks are the backers of a lot of these funds, and as long as we do not see a repeat of the financial crisis of 2008, the funds themselves should be fine, but it is still a risk that is present.
This is the era of social everything. Novel Brokers like Motif Investing allow for “crowd picking.” Every Motif is essentially a home brewed fund that a person can people can adjust to fit their own needs. They can focus on ROI, limiting risk, or on specific causes.
There are of course limits to Motif. The maximum size of a Motif is 30 stocks. That means you cannot make your own (SPY) like Motif. But 30 stocks allows for a lot of diversification, and you can always include index funds and other ETFs as part of the Motif.
Another alternative would be low/zero cost broker like Robinhood. While these brokers are not going to have the same kind of selection as larger companies, you can still easily get decent exposure in the market. While the nature of Robinhood makes it easier to buy individual stocks, as each trade costs $0, it still can be used to buy whole collections of stocks. You just have to do it manually, and would have to re-balance your collection manually.
There’s also factor investing, which is a form of active investing. The method looks at various characteristics of companies (factors) that differentiate one from another. Arbitrage Pricing Theory, a paper written by Stephen A. Ross in 1976, is the theoretical basis for factor investing. To explain the theory in detail would require an article of its own, however there’s a fairly solid, though admittedly theory intensive paper, made available by the Federal Reserve Bank of New York. Vanguard also has an article which discusses their factor based funds.