As we witnessed one of the longest bull market during the last decade, passive has been doing really well. In 2016 alone, fund inflow to passive investing was four times higher than the inflows towards actively managed funds, according to Morningstar. In fact, during 2009 to 2016, $340 billion was taken out by investors from active funds.
Index tracking has been the easy choice due to the unilateral direction of the market. Low fees are also among the reasons for the passive investing trend of the last decade or so. Of Vanguard mutual funds and ETFs, 226 registered $337 million in cumulative savings since December 2016.
When the market is going up, there’s no point in paying high fees to chase returns. Index tracking can do the job for you. Active funds, despite high fees, tend to perform poorly during an up market. According to The Economist, 27.6% of the best performing active funds during the five years to March 2012 turned out to be among the worst performing funds in subsequent years until March 2017. All in all, naive fund tracking would have landed investors with superior returns over most actively managed funds during the last decade. But this is not as straightforward in general.
Passive investing, for the most part, is fueled by a herd mentality
Passive funds have been on the rise, but it’s also a fact that the market is a perpetual up-trend for the past 10 years or so. Due to impressive performance of ETFs and other passive instruments, investors flocked towards these funds, increasing the overall valuation of the market without any regard to underlying companies and their business performance, creating a disconnect between price and value. Sure, investors continue to forgive the poorly performing companies due to the ecstatic market, but would this be the case once the market takes a turn for the worse? No, it won’t be the case because of the herd mentality.
Thanks to the combination of low-cost ETFs and the bull market, herding is at play. Investors are flocking towards these funds as they see their peers generate superior returns. This herd mentality is further boosting the already inflated equity market. A survey from the International Monetary Fund revealed that herding and confirmation are the top behavioral biases that affect investment decisions. Confirmation refers to searching for confirmation for one’s beliefs; passive performance has been providing investors with confirmation for the past decade or so. In short, the herding behavior fueled by the bull-run and low costs is fueling the passive market.
The point is that this herding will also affect the market during the next downturn. It’s not a one-sided phenomenon. If and when the market starts to go down, investors will withdraw from passive funds due to the same herd mentality that fueled the bull-run in the first place, putting further downward pressure on the market. Note that it is the same phenomenon of herding that makes it harder for investors to buy low and sell high.
Why it is not a good idea to stay passive going forward
The market is set to go into a bear run due to factors like monetary tightening, political conflict and privacy concerns. First, the liquidity from the market is about to disappear gradually as the Federal Reserve continues to shrink its balance sheet. This will affect the market through constraint on liquidity of financial institutions, leading to their withdrawals from the equity market. Moreover, rising interest rates are also not a good sign for the stock market. Increasing interest rates are associated with declining stock market returns.
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It can be seen that as the interest rate on excess reserves is beginning to climb, the S&P 500 is under pressure. The index is down 10% since late January. Interest rates are going to stay up from now on. The Federal Reserve has no intentions for a monetary easing going forward. Growth is strong and rate hikes are necessary, noted the chairman of the Federal Reserve, Jerome Powell, in his recent speech. All in all, the hawkish stance of the central bank will put pressure on the stock market going forward.
That’s not all though. Trump’s trade war and confrontation of Amazon (AMZN, Financial) is also bad news for the stock market. The market usually needs only a little nudge to go into a bear run. Privacy concerns regarding Facebook (FB, Financial) are also not helping the technology-oriented stock market.
To review, there are a lot of catalysts that can harm the stock market returns going forward. This can potentially follow withdrawals from passive, further pressuring the stock market. Consequently, passive investing won’t probably pay off during the next few years or so.
What are the options then?
An obvious strategy is to turn to value investing. In an up market, investors tend to forget value in favor of growth. Moreover, the passive trend of the recent past has caused the prices of stocks to grow uniformly, despite the underlying value. In an event of a bear market, the gap between price and value will most certainly narrow down, affecting mostly the richly priced growth stocks. According to study by Daniel et al. (2016), value stocks are less sensitive to major stock market declines than growth stocks. The study used the data for five market declines during 1987 to 2008. The researchers also noted the following:
“Further analysis using several hundred different significant market move events between 1980 and 2015 confirms the observation that value stocks tend to outperform both the market average and growth stocks during market declines.”
All in all, readjusting the portfolio towards value might provide protection against losses. This can’t be done using run-of-the-mill indexes. A hand-picked portfolio of value equities across sectors can be a solution. However, if you’re fond of passive investing, the so-called smart beta strategies can be used for tracking a basket of securities. For instance, ETFs tracking value stocks can be used to reconstruct the portfolio in case the market takes a turn for the worst. There are several smart beta ETFs that track value stocks, including iShares Edge MSCI USA Value Factor ETF (VLUE, Financial), iShares Edge MSCI Intl Value Factor ETF (IVLUE, Financial), Guggenheim S&P 500 Pure Value (RPV, Financial) and Cambria Global Value ETF (GVAL, Financial).
Final thoughts
The market is expected to remain under pressure during the months to follow, thanks to monetary tightening, trade wars and privacy concerns. Moreover, the market is also at risk from the herd mentality of passive investors. Going forward, investing in value or smart beta value ETFs can potentially save investors from gross losses.
Disclosure: I have no positions in any stocks or ETFs mentioned and have no plans to initiate any positions within the next 72 hours.
