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Mindless Passive Investing

Raphael Fiorentino
28th May 2018 - 5 min read
Paul Sinclair

The good times of mindless passive investing are over. Time to get truly active.

Man about to be knocked down by car due to inattention

In any sort of contest, it’s an enormous advantage to have opponents who have been taught that it’s useless to try
Warren Buffet

How then could so many put their faith in the efficient market hypothesis and their money in its earthly manifestation, the index-tracker fund?

Simple, passive investing is both intellectually convenient and a successful strategy over the past few years. But does this make it a fundamentally sound long-term one, would you buy a broken clock just because you happen to look at it on exactly one of the two times in the day when it happens to be right?

Passive strategies thrive under a set of circumstances that are the exception rather than the rule, as both laziness and obliviousness must be rewarded, while proper investment research must prove largely thankless in comparison. Put another way:

  • Stock market indices must keep rising and delivering returns that are well over that of cash rates over an extended period (ie. “laziness works”)
  • There must be little to fear in the way of volatility and maximum drawdowns (ie. “obliviousness works”)
  • The rising value of such indices must be primarily driven by its largest constituents, so that there is a relatively low percentage of outperforming stocks in the index, resulting in a median return of constituents being significantly lower than that of the index (ie. “thanklessness of research”)

Outside of the past few years, the indicators justifying a passive approach only went decidedly green once in 30 years

Period Laziness Obliviousness Thanklessness Performance
Index Net Return (1) Median Excess Return (2) Volatility (3) Maximum Drawdown (4) Out-performers (5) Winners Excess Return (6) Index Sharpe Ratio (7)
1983-88 1.00% -3.00% 19.00% -42.00% 47.00% 10.00% 0
1988-93 2.00% -5.00% 15.00% -18.00% 44.00% 9.00% 0.2
1993-98 7.00% -18.00% 12.00% -8.00% 33.00% (a) 13.00% 0.6
1998-03 -7.00% 1.00% 22.00% -26.00% 53.00% 8.00% -0.3
2003-08 4.00% 4.00% 14.00% -16.00% 57.00% 15.00% 0.3
2008-13 -2.00% 0.00% 27.00% -43.00% 55.00% 8.00% -0.1
2013-18 10.00% -5.00% 12.00% -10.00% 35.00% (b) 7.00% 0.8
  • An impressive 67% did return at least 5% over the cash deposit rate
  • A still very respectable 52% returned at least 5% over the cash deposit rate
  1. Annualised 5-yr return in US$ (MSCI ACWI from 1998, S&P500 prior) net of cash deposit rate
  2. Median return of each constituent of the index over or below the index return
  3. Annualised index volatility over the period
  4. Maximum monthly cumulated losses over the period
  5. Percentage of index constituents with returns above the index over the period
  6. Median return of stocks that outperformed the benchmark
  7. Median return of stocks that outperformed the benchmark

Never mind that the only way to rationalise a punt on passive is after the fact, and that the whole intellectual construct surrounding it therefore relies on dubious market-timing tactics.

The passive space is also crowded-out with countless ETFs (already far exceeding the number of individual stocks), whose supposed low tracking error and high liquidity will get seriously tested at the first serious drawdown or when 50% of the index constituents keep churning 10% while the index can do no better than 0%.

Conversely to a passive strategy (or worse still, a falsely passive one, consisting of chasing momentum with ETFs), a truly-active strategy selects holdings and constructs portfolios that explicitly targets minimum obliviousness (to prevent large drawdowns) and maximum thankfulness (to hold over 55% of future winners). The priority is to deliver solid returns over the cash deposit rate over the long-term. Outperforming the index during the few times when passive strategies do very well, is secondary.

There is an even bigger issue than mindless passive investing, and it is that of the mindful closet-indexers. Many active funds have no choice but to have it the wrong way around: short-term outperformance first, long-term return second. Investor short-termism (average holding period of a mutual fund is under 3 years), scale incentives (revenue model based on % assets under management), and passive investing tailwinds (forcing asset redemptions and no holding of cash in portfolio), all conspire to turn the industry into over-scaled closet-indexing funds. By positioning themselves to hug the index on the way up, they have compromised their ability to fare better on the way down.

Pictured below is a typical closet-indexing fund that was uploaded on butterwire: 2.5-3x more holdings than required for any to make a difference (1), likewise for active risk (2) and expected active return (3) which are too low, the sources of risk exposures are driven by industry (and geographical) bets (4) more than by stock-specific fundamentals (5) and controversies (6), and the portfolio’s expected resilience to a downturn is lower than that of the index (7)


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