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Peak Passive? Not so fast.4 min read

Sep 5, 2018 - Max Osbon ( 6 mins to read)

Max Osbon

The FT ran a story this week asking if we’ve hit “peak passive.” Similar to peak oil, peak “X” refers to an asset class hitting a sort of critical mass or market saturation. It also vaguely implies that there is no more room to grow and down is the only direction possible. With millions of investors relying on portfolios of passive index ETFs, this could be a mass catastrophe in the making. Or is it? Let’s take an objective look at the perils and possibilities of passive.

Planting the seeds of doubt

Active management fund fees are significantly higher than the fees of their indexing counterparts, so there is profit potential for active managers when passive doubt develops. Active managers have been trying to sow this doubt for decades.

Here’s an example. This week marks the 42nd birthday of the first S&P 500 fund by Vanguard. When it was launched, Fidelity founder Ned Johnson said, “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns.” The semantics in play here are important. Johnson tried to paint “average” as bad. However, that particular S&P fund has compounded at 11.06% per year for the past 10 years, outpacing Fidelity’s flagship Magellan fund’s 9.78% return over the same period. (Data from Bloomberg). 

It turns out millions of investors have indeed been completely satisfied to reap the benefits of owning broad market indexes, especially with lower fees, and often, better performance than active alternatives. Why wouldn’t they?

True concentration

Consider the maxim, “you get rich through concentration and stay rich through diversification.” In investing you achieve this concentration by investing in 30 positions or less. We see this in venture capital funds where 15 investments per fund vintage is considered fully allocated. PE firms are the same. Hedge funds often follow suit, holding as few as 10 highly concentrated “best ideas.”
For individuals, a handful of single stock concentrated positions is appropriate when held in a separate “best ideas” trading account. With fortunate picks that account can grow faster than the market as a whole, however, it could just as likely underperform.

Kanye West made some headlines last week when his basket of stocks from Christmas ‘17 outperformed the “market” by a large margin. He bought Netflix, Amazon, Apple, Adidas and Disney. The catch? The total investment was $300K, a tiny sliver of his available capital. When it comes to picking stocks personally, buy what you know and aim for high returns. Keep it small enough so that the event of a loss won’t significantly impact your emotional or financial coffers. Where to invest the other 95% of your available capital requires an entirely different approach and set of standards.

Passive isn’t as passive as it sounds

At $10B Snapchat’s market cap is larger than the minimum threshold ($6.1B) to be included in the S&P 500. So why didn’t it make the cut? The central issue has to do with voting rights. More specifically, holders of SNAP have no voting rights whatsoever. The board that governs the S&P 500 decided that it is imprudent to include non-voting stock in the index. Protecting the interests of the shareholders is effectively an active decision.

Proxy votes are another example. Two major institutional holders of Tesla stock are Blackrock and Vanguard, via their passive products. Blackrock recently voted to remove Elon Musk as CEO while Vanguard voted for him to stay. Passive managers hold the rights to proxy vote on behalf of the passive holders. That decision to hold or fold on Elon is effectively an active decision that will have a large impact on the price of TSLA.

Same same, but different

By and large, active mutual funds hold the same stocks as the index funds, just at different and more fluid weights. This is why many active funds have been accused for decades of “closet indexing.” When an index fund collapses or “pops,” the underlying stocks are the source of the losses, not the index structure. In that case, active funds holding those same stocks suffer, too. Stock values determine the value of passive funds, not the other way around. The “peak” argument just doesn’t follow the logic of the markets.

The goal of this article is to add context to an increasingly “anti-passive” news cycle. Keep in mind that many critics of passive have a financial incentive to stir up doubt. This is by no means a comprehensive report on the merits of active vs. passive as it relates to all markets and asset classes. We invite the conversation if you would like to discuss what it means to your personal investments. We’re here to answer the question, “What does this mean for me?”

 

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