Passive investing doesn’t remove the need to make choices

I’ve been thinking about the passive vs active debate for a while. There has been a clear shift towards low cost passive investing. Many personal finance bloggers are massive advocates of index investing, some preaching  very high exposure to US equities.  Bloomberg just published “5 ways ‘Passive’ Investing is Actually Quite Active” by Eric Balchuna. The media commentary seems to be shifting from a simple active vs passive argument, to a more nuanced discussion on what passive investing actually is.

When reading about personal finance / DIY investing online, it appears some people think passive investment removes choice from investing. That is, you don’t need to think about, or know anything about investing if you choose to invest passively. This is obviously not true. You need to make important decisions such as:

  1. Asset allocation decisions (e.g. equities vs bonds vs real estate vs cash)
  2. Geographic exposure decisions (e.g. Home country vs global)
  3. Index selection decisions (e.g. S&P 500 vs  S&P total US stock market)

The above 3 choices can have a profound impact on your long-term investment performance. To see the wide variation in 1Y, 5Y and 10Y returns across the 334 ishares ETFs go here.

In summary, passive investing is preferable for most retail investors, but it doesn’t remove the need to make choices.

If investment managers aren’t focused on driving down costs now, they soon will be

Good chart and discussion on the flow to passive funds at Abnormal Returns. Investors are decisively moving towards lower fee funds:

No matter how you slice the data the shift into lower cost funds is firmly in place. The chart below shows the nearly monotonic relationship between fees and fund flows over the past year.

6 questions everyone should ask when investing

Passive investing is all the rage. Active managers have been enriching themselves for decades, taking too much of the upside and none of the downside. Recent research shows the more outrageous hedge funds were charging up to 5% to 6% per annum in management fees plus a performance fee. The consistent underperformance of active funds has seen a dramatic shift in money to index funds and ETFs. Large, often underfunded pension funds are looking more closely at fees as well, in the face of underperformance and political pressure.

For most people, the sensible (but less exhilarating) approach to investment is clearly index funds or ETFs. However, this increasingly common knowledge does not provide guidance on how to invest passively. That is, which types of assets should you invest in, and how should the portfolio be allocated. Take a look at the historical performance of different Blackrock ETFs:

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Source: Blackrock website

There is a significant difference in returns over all time horizons. However, unless, you are Hindsight Capital, one cannot know which investments will deliver the greatest returns in the future.

Now, let’s look at the current situation:

  • American stock market is near all-time highs, with the S&P 500 trading at ~25x earnings
  • Interest rates are near zero, or below zero in most markets
  • China remains fragile, and no-one is really sure how fragile the financial system is
  • A loose cannon is in The Whitehouse
  • EU is still hobbling along
  • Technology continues to develop at a rapid pace
  • Service industry businesses are increasingly global and scalable
  • Despite all the noise, the global GDP keeps on growing

Some elements of the current environment are scary, others are comforting. For those seeking to invest, there are no easy answers. Investors need to choose a fund, or construct a portfolio which suits them. When doing so, I suggest asking yourself the below six questions.

Q1: Do I have enough cash set aside to deal with expenses to cover life’s ups and downs?

If you have insufficient cash set aside, you may be forced to liquidate assets to meet expenses when markets are down, which can destroy returns. You should be able to cover an extended period of unemployment or medical expenses without dipping into your investments.

Q2: Do I understand the fee structure?

Index funds and ETFs have the reputation of being low fee. However, more exotic ETFs can have fees over 1.5%. For low fees, stick to basic/core products offered by industry leaders such as Vanguard and Blackrock.

Q3: How liquid is the product?

ETFs are launched daily. More exotic and smaller ETFs can be less liquid than the core index products. This means they may trade at a significant variation to Net Asset Value, and be difficult to sell during volatile periods.

Q4: Do I understand what is in the index fund/ETF and implications for returns and risk?

Geographic and industry concentration are key considerations. Seemingly broad indexes can actually be highly concentrated. For instance the ASX 200 (200 largest Australian companies) ~40% financial services! Lessening concentration reduces risk (and potentially returns).

Q5: Am I the type of person who is likely to get nervous and pull money out of the market after a downturn?

Research has shown that many retail investor buy shares on the way up, and then liquidate after a crash, therefore missing the recovery. If you are prone to fiddle, a fund may be a better option than individually managing the portfolio.

Q6: Do I enjoy investing?

If you enjoy the process of investing, or the gambling aspect of it, you can set aside a small proportion of your assets for active management. Keep in mind, if you are investing in single stocks, or more exotic ETFs such inverse German bund products, there is the chance they go to zero or go up 100x. Make sure you are comfortable with the former, don’t bank on the latter.

So, what portfolio will give the greatest returns? No idea. Ensure you understand what you are investing in, and design a portfolio which allows you to sleep peacefully.