The True Cost of Passive Investing

It seems like passive investing — index and exchange-traded funds — have won the performance battle in today’s financial market. Trillions of investment dollars now rest in massive pools, while investors question why they pay active managers anything for investment advice.

But all good trends can be stretched too far. And a growing number of investors say that the indexing craze has created a bubble inflating the value of stocks across the market. Charles Brandes, founder and chairman of San Diego-based Brandes Investment Partners, is one of the voices sounding the alarm.

With bubbles, price dislodges from intrinsic value, says Brandes. Bubbles are difficult to catch because they can only be realized in retrospect, no matter how frequently the word is used on broadcast television.

Indeed, Ned Davis Research, the Florida-based investment advisory firm, made the following prediction March 2017: “We are in the last phases of a passive index bubble” presenting “a great opportunity for active managers to outperform” passive funds.

Davis sees the signs of excess everywhere. This time the distortion is different because of the breadth of the buying wave. The average stock in the Standard and Poors index rose to 2.5 times sales in 2018, compared with 1.6 times sales in 2000 encountered during the height of the dot-com bubble confined to growth stocks.

Investors need an active money manager for one simple reason: To protect the individual investors from themselves. As bad as active managers are at beating the indexes, it is equally true that individual investors are much worse.

Boston-based DALBAR’s Quantitative Analysis of Investor Behavior study shows that investors rarely spend more than four years in any fund or strategy. This devastates returns over time as investors sell when they should buy and buy when they should sell. Over the last 10 years, the average equity fund earned 11.02% a year, versus the individual investor’s 8.31% a year. The 32% difference more than makes up for any “excess” management fees charged by active managers.

The gap is widening as investors are becoming ever more sensitive to increasingly sharp market swings. Over the last 12 months ending Sept. 30, 2018, the average equity fund made 15.19%, the average equity fund investor made only 11% — a 41% difference.

Increasingly the decision on the mix and movement of money between index funds rests with individual investors — the people least adept at managing money, somehow convinced they should do it themselves.

In truth, they have become ever more vulnerable due to the impact of financial broadcast journalism — voraciously hungry for ratings, and not above pressing the panic button time and again. Look at what happened when the Ebola scare stories pressed airline stocks like American Airlines down to unprecedented lows, only to see the shares bounce back soon after the panic abated. How many times since the financial crisis have we allegedly been going into a recession or worse?

“Before we were having a bumpy road. Now we’re witnessing whiplash,” says Lou Harvey, DALBAR’s CEO.

Investors buy an active manager or an advisor, who chooses to be somewhat different than the markets they are trying to outperform, they count on the manager to exercise skills and experience accumulated over years of successful investing. They count on them to do everything they can to protect long-range returns. To an active manager heavily invested in his own venture, losses are not academic. Investing with an active manager, the investor is admitting that their financial ship needs a pilot and they are hiring one with the best style that suits their needs. They stop chasing performance and let their pilots do their job over at least a five-year span or longer. They focus upon long term goals, not short term gyrations and noise.

“What my studies call for is a trusted third party,” says Harvey. “The individual investor is not going to be up on the latest information. The manufacturers of financial products want to gather assets and sell products. Their goals are opposite that of the investor.”

Take the time to understand the high costs of changing your mind. The financial future investors save for should be their main objective not reacting to the crisis of the moment. T