Active Investing is Dead

Long live active investing.

Daniel Goldman
Mar 20 · 5 min read

Key Points

  • 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.

Shifting Revenues

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.

Cyclical Nature

Hartford Funds has an interesting white paper on the cyclical nature of active and passive fund performance.

Drawdowns

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.

Alternatives

Motif

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.

Robinhood

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.

Factor Investing

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.


Politicoid

Promoting a scientific understanding of politics and economics, sustainability, and freedom.

Daniel Goldman

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I’m a polymath and a rōnin scholar. That is to say that I enjoy studying many different topics. Find more at http://danielgoldman.us

Politicoid

Promoting a scientific understanding of politics and economics, sustainability, and freedom.