The active versus passive investing debate is relentless. If you do a simple cost/benefit analysis, advocates of passive investing have compelling facts on their side.

• Per the latest SPIVA scorecard, 82% of U.S. large-cap equity mutual funds lagged the S&P 500 index over the last five years.
• Expense ratios for active mutual funds typically range between 0.5% to 0.75%, while most passive index funds are between zero and 0.25%.

Why pay three or four times more for a product with an 82% likelihood of an inferior outcome? It makes active management seem like a silly value proposition.

However, like so many investing topics, there are nuances worth considering.

In the interest of leveling the playing field, here are five silly things about passive investing that don’t get enough airtime.

#1: It’s silly to invest more only because something did well in the past

The energy sector represents 5% of the S&P 500 and sports a 3.8% dividend yield. Ten years ago, the sector was 15% of the index and yielded 2.2%.

Are energy stocks a better buy now compared to back then?

Dividend-focused investors may think so. But passive investors owned a lot more energy a decade ago.

According to Ben Graham, the secret to investing is to figure out the value of something and pay a lot less. He called it a “margin of safety.”

Most passive products disregard notions of fundamental value and margins of safety. They are price-driven.

The formal definition of “passive” is a market-cap weighted basket of all stocks in a market. When stocks outperform, they receive higher proportional weights, while those that lag receive lower weights. Whether or not price moves are rational is irrelevant–price is truth.

If you believe in the Efficient Market Hypothesis (EMH), that sort of architecture may work for you.

After you experience a few asset bubbles, however, you may come to realize the EMH is malarkey. Then it becomes a lot easier to spot dislocations and harder to ignore fundamentals.

#2: It’s silly there are more stock indices than stocks

There are over 70 times as many stock market indices as there are quoted stocks in the world (source: Index Industry Association).

Let that sink in for a moment. It’s like saying there are more teams than players in a sports league.

Why so many indices?

Tim Edwards of the index investment strategy team at S&P Global says: “The users of index-based products are more active than they’re presented to be.”

Jack Bogle, founder of The Vanguard Group, may have had altruistic intentions when he set out to create a vehicle for buy and hold investors to save money on expense ratios. But that’s not the norm.

The reason there are a ton of indexes is because they make active trading easier.

ETFs are in especially high demand when volatility accelerates. For instance, ETFs represented 37% of all U.S. equity trading in December, according to BlackRock.

#3: It’s silly how many passive products overlap

Markets are ruled by supply and demand. Passive investors should know the proliferation of ETFs created an extra layer of demand that benefits certain shares more than others.

For example, Microsoft gets direct bids from investors who study the company and choose to buy shares. Then there’s a less discriminatory demand layer from investors seeking exposure to various factor cliques Microsoft belongs to.

Examples:

• Microsoft is the #1 holding in the SPDR S&P 500 ETF ($273 billion AUM)
• Microsoft is the #1 holding in the iShares S&P 500 Growth ETF ($23.6 billion AUM)
• Microsoft is the #2 holding in the iShares Momentum Factor ETF ($10.6 billion AUM)

Last June, I profiled for Forbes readers what I called my “Ronald Miller Index.” These were stocks I thought were receiving an artificial popularity boost from momentum-based ETFs. Since that article, those stocks have lost -4.0% on average compared to a gain of +13.6% for the S&P 500.

Passive investors should tread carefully and avoid pockets where herding can create an egregious disconnect between prices and fundamentals. This is more common in growth and momentum factor ETFs than in broader market proxies.

#4: It’s silly to think anyone is purely a passive investor

Do you know anyone who consistently allocates 100% of their financial assets to one passive index fund?

I don’t.

Also, what constitutes an appropriate passive benchmark?

Many associate passive equity investing to being 100% long an S&P 500 Index Fund, like SPY.

But if someone put all their money in SPY, we could argue they’re making an active bet, since the U.S. represents only about 54% of the global market.

In reality, most “passive” investors are actively passive. Meaning: they actively rotate exposures across asset classes, countries, sectors, and styles.

#5: It’s silly to passively manage risk

When somebody buys an index fund, they are guaranteed:

100% of the index’s upside

100% of the downside

Passive investing has existed for a long time, but it has really caught on in recent years. Conditions were ripe. 100/100 is a fine ratio in an environment typified by a lot of upside and little downside.

Here’s the rub, though: investment cycles mean revert. And eventually, we’re going to see a flip back to a multi-year period of lower returns and higher volatility. Will passive’s 100/100 ratio still feel like the right strategy then?

S&P 500 Cycles

It’s been well-documented in studies that investors abhor losses twice as much as they enjoy gains. That means our experience in a passive investment will not feel like 100 by 100. We feel the losses more.

Will a tiny expense ratio on a Vanguard fund seem like a bargain if the market declines over 20%?

At my firm, we don’t believe most who hire a professional money manager want someone to “passively” watch their back. So we’re in the active investing camp.

Researching stocks is a lot harder than allocating to indexes. The only reason I choose to do it is because I know active risk management can help smooth out the bumps in an investor’s journey. And at key cycle turns—it can make or break someone’s retirement.

To help illustrate how strategies can behave differently, my firm’s Core Equity Strategy has a historical upside/downside capture ratio of 94/74. This means during months when the market finished higher, we captured 94% of the upside. In months when the market generated a negative return, we were exposed to 74% of the downside. Not perfect, but we achieved positive asymmetry.

As someone who contends with market swings and the emotional swings of clients, I’m much more comfortable with my risk/reward ratio than I would be at 100/100. Especially now that we’re in a late-cycle environment.

But that’s just me. And what works for me isn’t necessarily right for everybody.

There are clearly positives and negatives to consider with passive and active investing. Depending on the framing, both approaches can appear downright silly. Conversely, both approaches can also work out well over time, if an investor has the discipline to stick with them.

 

Originally published by Forbes. Reprinted with permission. 

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