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Weekend Reading: Everyone Is Passive Until The Selling Begins

Courtesy of ZeroHedge. View original post here.

Authored by Lance Roberts via RealInvestmentAdvice.com,

“Apple has just announced that next quarter they will quadruple their sales of their iPhone X+ as every person on the planet now owns one.”

If that were a real announcement the stock price should immediately skyrocket higher, right? Nope, it didn’t.

In fact, it didn’t move at all.

Why? Because, no one bought or sold a single share.

How can that be?

Because the whole world is now “passively” investing.

Well, that’s the way a lot of advisors are proposing as the way you should invest. The problem is that it is lazy money management, so why are you paying for the advice, but more importantly, markets don’t function that way.

Larry Swedroe wrote a piece just recently admonishing active portfolio managers and suggesting that everyone should just passively invest. After all, the primary argument for passive investing is that active fund managers can’t beat their  indices over time which is clearly demonstrated in the following chart.

Oops.

There are large numbers of active fund managers who have posted stellar returns over long-term time frames. No, they don’t beat their respective benchmarks every year, but beating some random benchmark index is not the goal of investing to begin with. The goal of investing is to grow your “savings” over time to meet your future inflation-adjusted income needs without suffering large losses of capital along the way.

Don’t get me wrong, I admire Larry very much. However, it is important to understand a couple of important concepts around the “fallacy” of passive investing.

First, while my example above is extreme, the problem with even 20% of the market being “passive” is the liquidity issues surrounding the market as a whole. With more ETF’s than individual stocks, and the number of outstanding shares traded being reduced by share buybacks, the risk of a sharp and disorderly reversal remains due to compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.

As Howard Marks, mused in his ‘Liquidity’ note:

“ETF’s have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

Secondly, individual investors are NOT passive even though they are investing in “passive” vehicles. Today, more than ever, advisors are actively migrating portfolio management to the use of ETF’s for either some, if not all, of the asset allocation equation. However, they are NOT doing it “passively.”

The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks, rather than individual securities, it is not a “passive”choice but rather “active management” in a different form.  

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall the previously “passive indexers” will become “active panic sellers.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

It is only near peaks in extended bull markets that logic is dismissed for the seemingly easiest trend to make money. Today is no different as the chart below shows the odds are stacked against substantial market gains from current levels.

As my partner, Michael Lebowitz, noted:

“Nobody is going to ring a bell at the top of a market, but there are plenty of warped investment strategies and narratives from history that serve the same purpose — remember internet companies with no earnings and sub-prime CDOs to name two.”

Investors need to be cognizant of and understand why the chorus of arguments in favor of short-sighted and flawed strategies are so prevalent. The meteoric rise in passive investing is one such “strategy” sending an important and timely warning.

Remember, everyone is “passive” until the selling begins. 

Oh, I almost forgot, the other problem with the whole “passive investing” mantra is that “getting back to even” is not a successful investment strategy to begin with.

Just something to think about as you catch up on your weekend reading list.

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“What’s the difference between a pro and an amateur? Professionals look for what’s wrong with a setup. Amateurs only look for what’s right.” – Mark Harila


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