Richard A. Ferri, in his book The Power of Passive Investing, draws a vivid analogy between the active-versus-passive investing debate and the high-octane street gang rivalry of the Jets and the Sharks from the 1961 musical West Side Story. Although no visible swords are drawn on Dalal Street, Ferri’s metaphor is bang on the money.
When we look at the market share of passive index-based funds out of total money managed by funds, we find that it grew from a mere 5 percent in 1995 to a staggering 51 percent of the $8.5 trillion US equity funds in 2019. In India too, although still young, the trend is clocking considerable speed thanks to growth drivers such as Employees' Provident Fund Organisation (EPFO) and Securities and Exchange Board of India (SEBI).
What lies behind this radical shift? Passive investors will be quick to point to the disastrous track record of active managers, of overpromising and under delivering on market returns. Here’s a deeper look at what’s not working.
Active fund managers find it tough to beat markets
Over the last few decades, fund-management strategy advocates have been plagued by and acting upon the misconception that they have the ability to outsmart the market. However, evidence shows that the probability of an active fund beating an index fund irrevocably drops over time. In other words, even the best active managers are not likely to win the game. Their once-established practice of generating alpha — a measure of how well an investment strategy has outperformed an index fund — no longer delivers on its promise.
It is a well-known fact that any excess return from winning active funds is already well below a fair payout. To add insult to injury, the more active you are — that is to say, the more you churn your portfolio, the more money you end up shelling out in cuts, commissions and charges that go straight into your asset management fees.
A serious wastefulness attached to active investing is the cost of lost opportunities. In the case of investors that actively select stocks, buy, sell and monitor their portfolio to make profits, the active route requires them to spend close to 10-20 hours a week tracking the market. From the point of view of achieving one’s financial goals, this time could be spent a lot more productively to secure better returns another way. This is a huge hidden cost and defeats the long-term nature and purpose of investing.
The Shift to Passive
In contrast, passive investing puts its faith in the long-range view of the market, involving a methodical investment strategy that imitates an index. Research proves that low-cost index funds and ETFs that track market benchmark funds beat most actively managed mutual funds. Particularly for those who can’t afford to spend hours watching the market, the passive approach delivers a low-risk, low-cost, smart and transparent way to diversify.
As a general rule of thumb, 90 per cent of active investors tend to underperform the market. This means that even a purely mathematical person has nothing better than 10 per cent odds of winning. Clearly, active investors can fall in either bracket. But by simply choosing not to take on the perils of the active way, you are already outperforming 90 per cent of active investors.
Chasing stocks of large-sized companies
Because of the almost automated nature of passive investing, benchmark indices like Nifty 50 are consistently overvalued. Most ETFs get concentrated in the primary index which attracts the largest capital flows, leading to overcrowded large cap stocks.
The stock market exists to efficiently allocate capital to the most profitable businesses. This is further skewed within the weighty indices, where a default imbalance occurs when capital gets distributed equally across the board, neutralizing the outperformers.
As the unintended consequence of more investors engaging in passive strategies, large active management opportunities stand to emerge in the short term. Albeit in the long term, passive still wins as it delivers returns over a longer period of time.
The only way to avert these potential dangers is to exercise due diligence. Passive investing is not a substitute for diligence. Investors must allocate capital across asset classes intelligently to start with, invest systematically to protect their capital at all times, and wisely monitor and moderate the size of their investment based on current market conditions.
In recent years, ETF has become the quintessential passive product, delivering low-risk, low-cost, efficient diversification. Investors, specially millennials and first-timers, are faced with myriad investment choices but limited savings to start investing with. ETFs solve that. They trade for a fraction of the price of the underlying index, making them a great choice for beginners who are just getting their feet wet.For example, The Nifty index is at 13,000. But, Index ETFs are available at 1/10 or 1/100th the cost. So one can invest starting with 1 unit of ETF for as little as 1300/- or 130/- and get a good piece of the action.
If the stock market as a whole takes a turn for the worse, your index ETFs will likely fall as well. But in general, index ETFs are much less risky than holding individual stocks.
In the final analysis, disciplined passive investors who can power through temporary downturns will ultimately reap steady index-based returns.While active chases the mirage of beating the market, passive chooses to buy the market. With this simple switch of the lens, passive is not just investing in the future. It is building the future of investing.