The danger of passive investment.A popular investment strategy carries… | Author: Jonathan Baird CFA | The Capital | June 2021


Popular investment strategies are risky

In the past 15 years, the strongest investment trend has been the growth of passive investment, that is, the long-term purchase of investment instruments whose performance is linked to a set of relatively fixed investment instruments (such as stock indexes). The attractiveness of passive investment is not limited to individual investors, but also popular with pension funds and other institutional investors. Unfortunately, it is this extreme epidemic that may create conditions that put believers in passive investment at risk of significant losses in the next few years.

The popularity of passive investment is understandable. Passive investment vehicles usually provide lower fees and can quickly gain diversified exposure to the market or specific industries. Passive strategies are easy to implement and require little intelligence. 80% of actively managed mutual funds have historically underperformed the broader market index, which undoubtedly increases the attractiveness of passive investment vehicles. Passive investment strategies now account for nearly 50% of investment assets, and at the turn of the century, this proportion was about 10%.

But there is also danger…

It is worth noting that most of the growth of this passive investor group has occurred in a benign market environment. Except for the 2008 financial crisis and the sharp but short-lived market downturn in 2020, this growth is consistent with the continued positive market returns generated by the unusually low market volatility. Therefore, the experience of most passive investment vehicle owners is steadily higher with little fluctuation. In fact, compared to the historical average, the stock market volatility in the 2010s was extremely low.

The ease of use of passive vehicles reduces the desire of many people to gain investment knowledge through learning and experience. Therefore, passive investment has created a large number of investors with limited skills in dealing with the ever-changing investment environment.

When a bear market is inevitable, how will these investors deal with the volatility associated with the bear market? When faced with the psychological pain caused by a major bear market, investors with moderate experience in market volatility and negative returns may be more inclined to emotion-driven decision-making… This usually brings greater downside risks to passive investors and capital markets .

Meaningful selling by passive investment holders is likely to amplify market volatility, thereby generating further selling. The problem is that passive tools tend to concentrate their holdings on the most weighted components in order to replicate index returns most cost-effectively. This approach is understandable when people recall that the top five companies in the S&P 500 account for more than 20% of the index! Events that prompt passive investors to continue to sell may magnify the decline in the market index whose sales are concentrated on vehicles with the largest index weight.

Investors do not have the luxury of deterministic trading, but a series of possibilities. Our current era has a series of potential catalysts, which may generate significant market volatility, and stock market valuations and investor optimism are at extreme levels. The global economy is carrying an unprecedented debt burden, and geopolitical risks are rising. Although there are a variety of vaccines available to fight COVID, the potential threat posed by the emergence of new variants should not be ignored. The combination of these factors shows that the 2020s will be a very demanding decade for investors.

I believe that the answer to these needs lies not in passive investment, but in making investors more engaged and more “actively” managing their financial resources. Efforts to be more informed and active investors are beneficial to those who choose to make investment decisions on their own and to those who are willing to let others manage their funds by asking more informed questions to their advisors.

In short, economic and geopolitical forces are converging, and we expect this to generate considerable market volatility in the 2020s, which will eventually reward active investors and punish negative investors. Taking a passive attitude in any aspect of life (whether it is relationships, career, health or investment), rarely achieves the best results.

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