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© 2023 by Troy Springer

Is Passive Investing Really "Passive?"

March 7, 2018

 

How you can benefit from the successes and failures of passive investing

 

One of the fundamental changes to come out to the financial crisis of 2008 has been the shift to "passive investing." Passive Investing refers to using index funds that track a market index like the S&P 500 or the Russell 2000 (largest 2000 companies) or ETFs (exchange traded funds) which have recently grown more varied in scope and strategy.

 

ETFs can either be passive or active and can take to tracking themes artificial intelligence (ex.ROBO) companies to blockchain companies (ex. BLOCK) or even ETFs that follow a certain trading/ technical strategy like such as trend following (ex. QMOM).

 

The idea of passive investing was first made popular by Jack Bogle, the founder of Vanguard, the fund management company that now oversees as much as 4.7 trillion in assets, which --by the way-- is significantly larger than the fiscal budget of the United States (3.8 trillion). However, Jack Bogle himself has expressed concerns with the state of the passive investing industry as many of these funds are often not used passively.

 

Take a look at the average holding period of some of the top ETFs:

 


It is widely considered by both Bogle and financial academics that beating the market is an impossible and futile task. Jack Bogle would favor a never sell strategy, not the 31 days that investors hold "SPY" the largest ETF by almost a factor of two.

 

 


 Before the financial crisis, comparable investment vehicles at a .5%-.8% expense ratio (the percent of your investment collected in fees to run the fund) simply did not exist. It seems to me that many fund managers have merely switched from being "Active" fund managers (Mutual Funds) to Actively managing "passive" ETFs. Creating these funds is almost a more attractive offering to many managers as they are simply tasked to produce a product that tracks a certain investment idea, and not necessarily be on the hook to produce outperformance (known as Alpha). Thus many investors flock to these ETFs under the guise that they are entering "passive" safer investments, while in fact, they do not follow the Bogle model of passive investing.

 

While I am a stock picker at heart, taking advantage of some of these investment products can be advantageous, particularly in sectors that are difficult to understand. For example, consider the Biotech sector; understanding Biotech companies often requires an understanding of medical practices, and many of these companies have no fundamental investment characteristics (earnings, cash flow, etc...). However, the Biotech sector is often home to some of the largest sources of outperformance. Why not own a Biotech ETF (ex. XBI)curated by someone with specific industry knowledge while paying as little as a. 5% expense ratio. Other ETFs can even provide downside assurance such as Cambria's Tail Risk fund (TAIL).

 

However, these fancy investment produces while valuable can also contribute to some potential market problems. As the world continues to buy baskets of companies instead of individual stocks that leaves room for assets to be mispriced as more money is moving in and out of stocks without considering the individual merits of certain stocks rather the market at large.  Vanguard alone owns 7% of the entire S&P 500. This could potentially be an advantage for stock pickers who seek out mispricing in stocks.

 

Furthermore, where many investors have learned the discipline to hold individual stocks for the long run, investors may be quicker to pull the trigger and sell passive funds in market downturns as there is no emotional connection or fundamental investment thesis to justify the value of the asset.

 

SPY lost 8% of its assets in just five days during a market correction (when the market drops by 10% in a short time). Take a look at this chart from the latest market "correction" in the stock market in February:

 

 

 Yikes. As blogger Josh Brown put it: Passive my A**!

 

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