The debate about Active Vs Passive investing

The Media debate about Active Vs Passive investing always revolves around the fees paid vs the returns generated however is the choice as simple as that today ? Passive investing has worked really well in the past however does that mean it will continue to do so in the future.

Passive investing strategies have been a huge beneficiaries of a comment attributed to Warren Buffett that if he was to give advice to others he would recommend investing in a S&P 500 ETF rather than have an active fund manager. This has given huge horsepower to the flow of funds to passive investing strategies based on a the comments of arguably the worlds greatest active investor and someone one that is very likely to have $0 of his own funds invested passively.

Read on;

The US share markets are at or close to record highs depending on what days you are looking at them. There are economic issues world wide be that slowly growing economies such as US, Aust and others, recessed economies through Europe or economies that were growing strongly and are now slowing eg China. There are geopolitical factors happening in the world. Brexit, Sabre rattling amongst some world leaders and outright war and skirmishes around the world.

That being the case why is the Vix index so low ? The Vix measures the volatility in the US share markets and it is telling us that today more than anytime in the past the investors are more confident or less worried about the future than ever before. Does that really make sense or are there other factors at play ? Perhaps investors are thinking there is no where else to invest that will give you the risk adjusted rates of return compared to equities. Surely Equity markets still have some risk involved ?  You don’t get that impression looking at the Vix as there is very little volatility on a historic basis which could be interpreted as very little concern about risk.

Perhaps the issue is that no one is thinking anymore in global share markets.
I was at a PD day recently where one of the global research houses where discussing Passive Funds management vs Active Funds management. They stated that in the US Passive investing through index funds and ETF’s accounted for nearly 50% of funds invested. Further they said of the 50% of actively managed funds 15% were invested so close to index weightings that it is hard to argue that the fund manager had any active position.

Given these numbers it could be said that up to 65% of the US market has funds that are being invested without any thought process behind what is being purchased. Perhaps the Vix is telling us not that the markets are not volatile anymore perhaps the Vix is saying that the passive investment strategy by sheer weight of numbers has over powered the active managers.

The volatility has gone as the underlying trend is up. New money is invested in equities due to the returns of shares compared to other asset classes such as cash and bonds and no one is thinking about how that new money is invested.
The Passive process is “More money to invest, the computer places the trades to purchase the shares according to the index weightings”  The profitability and growth of that profit in company X is one factor that is not considered in the Passive investment process and that is apparently now how the majority of money is being invested in the US share market.

Passive investing may be healthy and efficient as it is cost effective and technology has taken over from brains as has been the case in a lot of other industries. Interestingly though in times of extreme market volatility the regulator has mandated that computer trading must stop and brains must be engaged to make decisions.

If the weight of approx 65% of investment mandates are done on a passive basis no one is actually asking is company X really worth that ?

Indexing works very effectively when you have active managers and hedge funds taking active positions and arguing the point about what company X is worth. In that environment the index is the outcome of that price discovery debate and passive index strategies work really well and cost effectively. This has been outstandingly successful over many many years to the extent that indexing and ETF investing to track indexes has seen very strong inflow.
The key question is, “Now that the Passive Management fund flow has overwhelmed the Active management flow, can passive investing work as well now as the price maker due to their trading volume rather than passively following the market cost effectively?