In re­sponse to crit­ics of pas­sive in­vest­ing

A num­ber of crit­i­cisms has been lev­elled against pas­sive in­vest­ing. But Si­mon Brown says ac­tive man­agers only have them­selves to blame if they un­der­per­form the mar­ket.

Finweek English Edition - - MARKETPLACE - Editorial@fin­


year there was a much-her­alded ar­ti­cle com­par­ing ex­change-traded funds (ETFs) to Marx­ism, writ­ten by some­body who seemed to have a very loose grasp on both Marx­ism and pas­sive in­vest­ing. Now re­cently my in­box has been flooded with peo­ple send­ing me the link to an­other ETF-bash­ing ar­ti­cle ti­tled Has Pas­sive Man­age­ment had its Day?

Broadly, both ar­ti­cle have the same theme, stat­ing that, with the surge in in­ter­est and hence in­vest­ments into pas­sive in­stru­ment, we are dis­tort­ing the mar­ket. The ar­gu­ment is that pas­sive funds just buy the stocks within their bench­mark with­out any con­sid­er­a­tion for qual­ity, value or re­turn. In con­trast, ac­tive man­agers would care­fully select the qual­ity stocks, re­ward­ing them as the buy­ing sends those share prices higher, while sell­ing the los­ing stocks, send­ing their prices lower. In short, the ef­fi­cient mar­ket the­ory.

Does pas­sive in­vest­ing dis­tort the mar­ket?

The con­cern here is that with in­creased pas­sive in­flows, mar­kets then rise with no con­sid­er­a­tion for qual­ity. With­out this con­sid­er­a­tion mar­kets will just con­tinue ris­ing un­til there’s a fa­tal crash. Yes, you will note this is ex­actly what has hap­pened re­peat­edly through­out his­tory long be­fore pas­sive in­vest­ing came along.

Frankly, if 90% of in­flows were into pas­sive prod­ucts, the few re­main­ing ac­tive man­agers would have a field day be­cause the the­ory is that these pas­sive in­flows would cre­ate a very in­ef­fi­cient mar­ket. This would make beat­ing the mar­ket easy for the re­main­ing ac­tive man­agers.

How­ever, the real story is that ac­tive man­agers who spend their days be­moan­ing pas­sive in­vest­ments and telling us how evil they are should rather fo­cus on beat­ing the mar­ket. The rea­son why pas­sive in­vest­ing has be­come so pop­u­lar is be­cause the ac­tive in­dus­try charges high fees and all the clients get are funds that mostly un­der­per­form the mar­ket. If ac­tive man­agers charged less and beat the mar­ket con­sis­tently, we would not be hav­ing this de­bate. It is the fail­ure of ac­tive man­agers that is the prob­lem, and blam­ing pas­sive investors is just the easy ex­cuse.

Ac­tive man­agers have had their chance

For over a cen­tury, in­vest­ment prod­ucts have been ac­tive and one-sided in favour of these ac­tive man­agers and the in­dus­try. These ac­tive man­agers have not fo­cused on the lit­tle per­son try­ing to in­vest their hard-earned money to en­sure a de­cent re­tire­ment, nor have they per­formed well.

For far too long now, investors have been sold hor­rid prod­ucts with crazy fees that fail to per­form. An ex­am­ple of this is the long-term in­sur­ance in­dus­try, which has di­vi­sions for closed prod­ucts. These closed prod­ucts are the ones they used to sell like mad back in the 2000s and ear­lier, al­though this is no longer the case. These were over-priced and un­der­per­form­ing non­sense prod­ucts that in most cases turned out to be very poor long-term in­vest­ments. Wor­ry­ingly, the clients hold­ing these hor­rid prod­ucts are not be­ing con­tacted by the in­dus­try with of­fers to switch into newer, bet­ter prod­ucts; they just leave you in the stew.

Pas­sive man­agers must ex­er­cise their rights to vote

An­other, but less fre­quently men­tioned, crit­i­cism of ETFs is that pas­sive man­agers do not bother to vote at an­nual gen­eral meet­ings (AGMs). In­deed, they don’t and this is a con­cern. But it is also an easy prob­lem to solve in that pas­sive man­agers could vote. The pas­sive man­agers could make use of in­de­pen­dent ad­vice on how to vote and then vote ac­cord­ingly.

At the end of the day pas­sive in­vest­ing is still in its in­fancy and, as Mark Twain is al­leged to have said when a news­pa­per pub­lished his obit­u­ary: “The re­ports of my death are greatly ex­ag­ger­ated.” I am con­fi­dent the same ap­plies to pas­sive in­vest­ing, and the ac­tive in­dus­try needs to stop com­plain­ing about pas­sive and start work­ing out how they can add ac­tual value to investors, be­cause so far their value-add has been mod­est at best.

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