Why there is no such thing as passive investing.
The basic theory is great: we can get exposure to financial markets in a very cost-efficient way, by buying so called index funds that track the major markets, such as the FTSE 100, the S&P Corporate Bonds index or even the price of Gold. However, that’s also where the story ends. In other words, it’s great that we can buy so many different index funds, but there are more than 10,000 to choose from. Which ones we buy, in what currencies and how much of our capital we put at risk will have a huge bearing on how much money we can earn.
The whole notion of passive investing, whereby we do not have to make active decisions or worse pay someone to do it for us is highly misunderstood. For sure, it is much cheaper to buy index funds than trying to pick specific stocks or bonds in an effort to do better than the market. According to statistics from the Financial Times, 99% of active managers fail to beat their benchmarks. Most of that has to do with fees. Index funds cost next to nothing (Vanguard and Blackrock offer several of their funds for zero management fees), whereas active funds are still highly expensive, commanding fees of 1% on average per year.
However, there are much bigger issues than fees that determine our success in making money. The so-called strategic asset allocation accounts for 90% of the returns of any investment strategy. In other words, it is not what we buy, but how much. Here is the math: let’s say that you wish to build a diversified portfolio of stocks, bonds and commodities. Going passive means, we buy three index trackers costing 0%, versus buying three actively managed funds costing 1% each. Compounding that over 10 years, means we can save 10.46%. Great. However, the decision of whether to put 30% or 70% of our money in equities, could end up costing 37.02% (assuming stocks rise by 8% per year).
There simply is no “passive” way to allocate our assets, it is akin to saying that the same size of house should have the same price, no matter the location. But it gets worse, because the biggest risk in any investment portfolio is down to the exposure to currencies. The Sterling denominated FTSE 100 index has underperformed the globally diversified MSCI World index by 101% in the last ten years. Not all of that is due to currencies, but whether Sterling rises or falls versus the US Dollar or the Euro is clearly a large component of our returns.
So, the question is, who makes these decisions? As much as people always look at fees in choosing their investment managers, the issue is akin to being penny wise and pound stupid. Without a doubt, passive index funds have revolutionized the way we can get exposure to investment risk, but the decisions in constructing a successful investment portfolio remain the same, and are as active as ever.