November 16, 2016

Passive investing could to mediocre performance

Though a few paragraphs are not enough to explore the active/passive debate, I will make some observations and conclusions.

Passive investing has begun to dominate active investing over the last five years. This should not be surprising, as:

-    Retail investors have faced two large drawdowns in the market averages, in 2000-02 and in 2007-09. As well, many popular (and low-priced speculative) stocks have burned individuals.
-    Institutional investors have also fared poorly. Mutual funds have materially underperformed the averages. Hedge funds have failed to "hedge" during The Great Decession and, more recently, many have glommed unto many of the same doomed stocks.
-    In a low-return setting, high fee active managers have suffered versus lower-cost passive competitors and have lost market share.
-    Quant strategies (volatility trending and risk parity trading) have upended the institutional money management business, taking inflows away from dissipated active hedge funds that are collapsing these days like cheap suits.

With the passive tide coming in and the active tide moving out to sea, the latter appears to many to be swimming naked.

To some degree, the flows into passive vehicles resembles the preference and inflow surges into "risk-free" bonds over "risky" equities, which are astonishingly occurring at a time when interest rates are zero or lower.

That commonality -- of passive over active and bonds over stocks -- should warrant caution and could represent, as I have written, one bubble forming and another bubble about to be pierced in fixed income.

You Get What You Pay For

From my perch, choosing to save money by spending less for active management in order to improve results is an ass-backwards approach that historically has backfired. By implication, it negates the search for value, which is at the core of some very successful long-term investors such as Warren Buffett, Benjamin Graham and David Dodd, and the underlying precept that superior investment management is not worth the effort.

But, as it is written in Ecclesiastes, to everything there is a season. Or, as I have often written, mean regression is the most common feature of economic cycles and in human behavior.

While we may not know how extreme a cycle will get, we damn well have learned that an extreme in one direction always leads to another extreme in the opposite direction.

The speculative move in the 10-year U.S. note yield to 1.35% in early July 2016 is arguably one such historical extreme, just as the near-20% bond yields of the early 1980s was another extreme. Indeed, looking further out in history and starting at the end of World War II, we have had two separate 35-year cycles in a row in fixed income -- both likely ending in extremes.

Conditions Are Ripe for Change

One characteristic that cycles and human behavior share in common is that
acceptance is a feature near the end of every one of those cycles. That helps to explain why being premature in anticipating a cycle's end can be as expensive an exercise as being caught in the turmoil that accompanies a trend change.

This also helps to underscore the value of passing up (as the extreme compounds) on some potentially large gains that occur at the end of a speculative move (e.g., in tech stocks in late 1999/early 2000 or bonds now).

Remember, new paradigms are, more often than not, not the "new normal." Rather, they are a figment of investors' imagination and a manifestation of their greed and herd behavior.

Passive Investing Is the Path to Mediocrity

From my perch the present fondness and popularity of passive computer-based investing is another cyclical extreme that we have seen in other asset classes over the years.

Diminishing the value of active money management and research and raising the value of less expensive and less time-consuming "robo investing" and/or algorithmic trading that exploits minute price inefficiencies also raises the risk of crowd/herd behavior, which has been prevalent at previous market tops (e.g., portfolio insurance in 1987, the 1997-2000 tech boom and, finally, in 2007, which lead to The Great Decession).

I have been of the view (anticipatory vs. reactionary) that this sort of crowd behavior is much better played against than rewarding in itself. But, more importantly, I will almost guarantee that, in the fullness of time, an association with passive investing will lead to mediocrity. And, I promise you that active management delivering fundamental Graham and Dodd analysis, which gives recognition to private market value and is not agnostic to balance sheets and income statements, will be rewarded.

Emerging Evidence of a New Dawn for Active Management

The fact is that, even as the momentum of passive and algorithmic investing intensifies, we already are seeing a sharp contrast in strong and weak groups/stocks. Just look at consumer discretionary versus technology, bank stocks versus REITs, Facebook (FB) versus Twitter (TWTR) , and so forth.

Passive investing is not currently capturing this distinction and active management has begun to produce better results over the last few months. This development, in and of itself, when clearer to investors, could slow the trend away from passive toward active investing.

But, herds operate together and are slow to deviate in behavior until it is more obvious.

Bottom Line

To everything there is a season.

Passive investing may be cost-efficient, but it ultimately will lead to mediocrity.

While every investment selection process has its pitfalls and weaknesses, the emphasis on delivering a low-management, fee-based passive product is ultimately doomed and, in the fullness of time, again will be replaced by a growing, differentiated and active investment process.

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