The problem with passive investing

There has been a lot of talk these days about how many active stock managers have underperformed in the past number of years.

Much of this talk includes recommendations that investors move all their money from active management into indexed ETFs and mutual funds (passive investing). Talk about near-term bias.

This recommendation is based almost solely on what has happened in the past few years in the U.S. If they look back further, and in Canada, their recommendation doesn’t work so well.

To provide a bit more context, due to the conditions in the last few years, many view passive investing as “safer” or a better option than active investing, but that is not necessarily so.

Passive investing is dependent upon specific market conditions.

My experience as a longterm investor has been that index products are difficult for active managers to keep up with in rapidly advancing markets as they are always fully invested and, by definition, keep investing more money into the stocks that are rising the most. The big get bigger and it feeds on itself. Until it doesn’t.

This is momentum investing, not value investing — which is what we do.

Value investing is an investment strategy where stocks are carefully and precisely selected when they have the most value to the investor — meaning they have the most room to grow and become profitable.

Value investors actively seek stocks they believe the market has undervalued. Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company’s long-term fundamentals, providing an opportunity for profit when the price is at its weakest.

The rapidly advancing type of market is what we have seen in the U.S. since the bottom of the financial crisis in 2009 and this is the time period most of these people are basing their opinion on. It is also reminiscent of the late 1990s when technology stocks totally dominated the S&P 500 and Nasdaq. By the end of that bubble in March 2000, five out of the 500 S&P stocks accounted for almost all of the total daily movement of that index. Some of the Nasdaq leaders of that year no longer exist. Speculation ran wild, but if you were a passive investor you owned those stocks.

I’m not so sure these people were touting passive management for a number of years after that debacle. They have waited for their ideal conditions to do that again. However, investing is not about ideal conditions, it’s about knowledge, experience and understanding of the markets.

In gently rising, flat, or down markets, active stock managers tend to beat index products. The U.S. has not really seen this type of market for quite some time. Not since 2008.

But it will again and then watch out. Remember how poorly indexes did in 2000 and 2008?

Also, let’s go back in history in the U.S. (which has the most reliable and longest available data set) to 1906-1926 or 1936-1950 or 1965-1982 when markets were flat. Nobody would have made any money in index products then, had they existed, but stock picking managers would have had a field day due to market volatility. This can and will happen again. Maybe sooner than most people think.

Canada is a different story as our market is dominated by resource and financial stocks, which make any index product, based on our stock market, an extremely poor product for anyone to sell or buy.

The fact of the matter is that the S&P/TSX Composite Index bears absolutely no resemblance to Canada’s real economy.

Actually, the S&P/TSX Composite Index has historically been the worst constructed major index in the world. Takeovers and privatizations over the years of many of Canada’s biggest and best companies ensured that. Whole major industries have disappeared from Canada’s public markets. Besides its resource and financials bias, the S&P/ TSX has, over the years, often been dominated by one single stock. Think Nortel, BlackBerry, Valeant, and others — That is not a proper gauge of the economy as a whole.

How did that work out? If you were invested passively in Canada, what would your returns have looked like?

We believe that investors should invest with a specific goal in mind and that equalling or beating an index is not an investment goal. Indexes are irrelevant for individuals.

They are relevant only for fund managers as a benchmark for how they are to be paid or for those same managers to be hired and fired by pension funds and their consultants. They don’t mean anything for anyone else.

Individuals should have goals based on their longterm needs and risk tolerances and ignore the swings in the stock market. They are irrelevant to you and your goals.

Being contrarian thinkers, our antennas are up when there is such a powerful push toward passive investing and massive amounts of money are flowing into these products.

Can anyone say “bubble?” Investors should invest with a specific goal in mind and equalling or beating an index is not an investment goal, the Financial Post’s Norman Levine writes.