I Solved the Passive Investing Debate

Passive is one of the most polarising strategies in modern investing.

In retail, the battle is over. Done. Finito. Passive investing won. You won’t get many retail investors who strongly oppose this method. In fact, many see it as the only way non-professionals should be investing. They think it’s obvious – just look at how well the strategy has worked in the past, how cheap it is, and how easy it is.

But some retail investors don’t employ passive investing (PI). This is because they think they can out-perform this strategy by picking individual assets themselves. Professional investors also tend to sneer at its effectiveness. This sneering tends to become particularly visible in times of market turmoil – when passive investors are philosophically unable to divest. The argument that causes the sneering is that the white-knuckle commitment to holding a collection of stocks – even when investors would be better invested in other asset classes – is an unnecessary and financially painful approach.

This clash seems to have come to a head recently. Elon Musk has claimed that the popularity of PI has increased volatility. This view has been supported by recent academic work that claims that the price elasticity of demand for the aggregate stock market is low, causing the increase in volatility that Elon alludes to. The idea is that less active volume results in less liquidity, which means relatively small order sizes move prices substantially.

Why It’s Good

Economic growth

If you own the biggest companies in a certain geography, and the economy of that geography is growing, these companies are likely to be growing, too. This is collectively inevitable: these companies employ the most people, attract the most consumer spending, have the most partnerships with other companies, etc. So growth anywhere in the economy, even if its source isn’t the big companies, will likely result in this phenomenon.

Growth means more cash flow. More cash flow means higher valuation (via discounted cash flow analysis). Add this to the fact that people now have more disposable income to spend…on stocks. The prices of these publicly-traded companies tend to increase as the economy grows as a consequence of these phenomena. Hence the value of the index, a collection of these companies, grows too.

Performance tracking

PI is a way to automatically invest in companies that have performed well in the past and have continued to do so.

To be accepted into any index you have to display some competence in terms of growing a company and delivering value to investors. I can’t list the new business my brother and I launched last week on the London Stock Exchange and have it be part of the FTSE 100.

Companies only get accepted into indices based on a set of strict criteria. These criteria are only met by high-performing companies. Companies similarly get removed from the index if they begin to fail to meet these criteria, by performing poorly for a sustained period of time.

Most indices are also weighted by market capitalisation; companies that perform better grow more and reach a higher market capitalisation.

By these two mechanisms, indices become composed of companies that have historically performed well. So if you believe there is some persistence in company performance, meaning that historic performance is some indicator of future performance, index investing is likely to return more than investing in a larger collection of assets.

That’s a big if. Companies that have performed well may have better culture, leaders, product, employees, brand, etc. They might be the leaders in a growing market, with some type of monopoly, attracting all the deals and talent and investment within that market. But they must just have been lucky and due some type of regression-to-the-mean-type downward correction. As you grow large you’re also vulnerable to stagnation. It’s hard to innovate and keep up with the constantly-evolving economy and market. There’s a reason companies go extinct on a regular basis.

Non-financial returns

Return isn’t actually the main benefit of investing passively; the main benefits of PI are those not reflected in the gross return of the fund. Gross because cost is a huge factor. PI is cheap. These costs (or lack of them) add up over time, especially when you factor in the effects of compounding. Also important is the time and effort required to invest. Because PI is an established strategy, there is a rich community built around executing it. There are books, Reddit communities, podcasts, Twitter “personalities”, etc. all dedicated to it. It’s easy to understand and implement.

What else is there?

When PI is attacked, convinced retail investors may find themselves turning to the attackers and asking “Ok – so what should I invest in?”. Outside of “My fund”, the response tends to be one of “Do your own research”, “Get a financial adviser/professional investor”, “Don’t invest”, or “Use a diversified mix of selected assets based on criteria X, Y, and Z”. These are all useless and/or incorrect responses.

Retail investors kind of sort of find themselves forced in some ways to use PI. There is no good alternative.

Why It’s Bad

Exploitation

PI works in a rigid, boring, robotic way. Investors often invest a set amount, at a set time, in a set index or collection of indices.

One consequence of this is that financial hyenas can take a piece of PI capital flows. These hyenas know what companies are in/will be added to the index and the fact that massive, automatic inflows occur on a regular basis into these funds. They know what proportion of each company these funds have to hold. At all times.

These constraints mean that PI is subject to exploitation by active investors (the hyenas). And the problem gets worse as more people use PI because the value and volume of these opportunities grow.

The more people use PI, the more profitable exploiting PI becomes. And because investing is a 0-sum game, this comes at the expense of passive investors.

Concentration

PI vehicles weighted by market capitalisation can become concentrated.

This is because company size is not normally distributed, it’s waaaay more kurtotic. For example, the FTSE 100 companies represent around 80% of the market capitalisation of the London Stock Exchange. The top 10 stocks in the S&P 500 in August 2020 accounted for over 25% of the index’s capitalisation.

This dynamic means that passive investors counter-intuitively often don’t enjoy the diversification that active investors have at their disposal. They are often more heavily invested in the large stocks, meaning they are exposed to the fortunes of these stocks.

Tail risk

A major criticism of PI is the lack of tail-risk hedging involved in the strategy. When the market goes bad passive investors suffer. Imagine the value of your portfolio decreasing by 20, 30, 40%? And remember, it requires a 100% gain to make up for a 50% loss. Now imagine this loss triggers an uncle point, or it happens just before retirement, or an emergency.

Up only

And that’s with the assumption that the market went up for a sustained period of time before that, which might not be true. Americans struggle to comprehend this because of the remarkable performance of the S&P 500 over the last 100 years. Taking a look at the performance of other markets, in other countries, might make you pause, sit back, and consider if the market does always go up in the “long term”. This is something that PI is completely and utterly reliant on and thus vulnerable to.

Actively passive

I’ll let you in on a little secret: passive investing isn’t passive. It’s a myth. You have to actively choose which assets to purchase at which times and in which geographies. There is nothing passive about these decisions. And even if you think you’re making a passive decision à la “I’ll just buy the S&P 500 every month”, you are not. You are making a conscious decision to only invest in the top 500 stocks in the USA. This is a small % of the assets available to you to invest in. And these companies are selected by a committee, using specific criteria. 

You must make a decision. The question is how to make that decision. But it’s not clear what we should a priori optimise for. Shall we construct a portfolio that reduces the probability of a loss? Or the probability of unfavourable outcomes over our time horizon? Or how about one that has the potential for the highest returns?

This is all sounding very active.

Everyone’s Wrong

Blindly following a prescribed PI strategy is dumb.

PI is not magic. It comes with decisions to be made and risks to take. The main benefits are non-financial. The investment ‘edge’ is psychological: if you can buy and hold for a long period of time and construct a diversified portfolio, the effects of longevity and compounding and your psychological advantage will mean that you’ll probably do well.

Dismissing PI as a viable strategy is also dumb.

Critics have some good points but their arguments are hurt by the fact that most of them (the critics) rely on the fact that the more popular PI becomes, the less capital flows towards their funds (those owned by the critics), and the less money they make. Be wary of those who criticise PI whose income is hurt by its success.

The fact is that there are no good alternatives. Holding cash will leave you crippled by inflation. Active management is largely a con. More sophisticated strategies require a huge time and effort commitment…and even then probably still won’t work. 

Passive investing is still the best option retail investors have.