The passive approach: buyer beware

Brandon Snow's picture

According to Merriam-Webster’s dictionary, passive is defined as “used to describe someone who allows things to happen or who accepts what other people do or decide without trying to change anything.”

Obviously (and self-servingly) we are proponents of active management – we believe that a consistently applied investment philosophy will, over time, deliver better and higher quality returns than the market as a whole. It is well known that, in aggregate, active managers don’t add value. This is due to the fact that the number of mutual funds is so expansive that the industry in aggregate matches the market, and therefore in total, after fees, we don’t add value.

The ETF marketing machine has latched onto this to offer – in essence a cheap, average approach. This is in regard to plain vanilla ETFs, not the exotic ones which have hidden costs, but we can leave that discussion for another time. I have never understood why anyone would want to find the cheapest option for something as important as their personal savings. Anyone who has gone through a home renovation knows the “cheapest” option often costs you more in the long run!

Nonetheless, the ETF marketing machine has been hugely successful, and hundreds of billions of dollars have flown out of actively managed mutual funds into ETFs. The following charts are taken from “Passive Vehicles & the Profit Penalty”, a very interesting paper, courtesy of our friends at Kailash Concepts.

When you have this much of an imbalance, strange things start to happen. In this case, the “passive” approach is giving price support to all companies, regardless of their quality. As you can see in the following chart the percent of companies that are loss-making in the market is close to all-time highs:

Source: Passive Vehicles & the Profit Penalty. Kailash Concepts, January 2015.

What makes this skew even more impressive is the fact that it’s occurring during an economic boom. The previous times we have been here were during recessions when profits are cyclically depressed!  When investing, you have a much better chance of making money investing with profitable companies.  It seems the massive flow into passive products may be causing complacency with respect to company fundamentals – exposing passive investors to a lot of companies with a low probability of beating the market. Luckily, as active managers we have a very easy decision to make; avoid the money-losing companies.

Comments

Submitted by Tim Hazlett on

Brandon,

It is about time we start seeing great articles letting investors know the truth about so called lower fee alternatives to mutual funds such as ETFs. It seems our whole industry is getting beaten to pieces with the negative news in the media and investment industry about mutual fund fees and embedded commissions. Thanks for being great investors for my valued clients' money and standing up to the naysayers!

Regards,
Tim

Brandon Snow's picture
Submitted by Brandon Snow on

The thing is, the mutual fund industry could use some pruning. But like so many things in the market, if everyone agrees something is a good idea, it ends up being not such a good idea!

Thanks for the support.

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