W. Scott Simon
Given my suggestion in last month’s column that passive investing is the “default”
standard for modern prudent fiduciary investing, I though it might be worthwhile to
dispel some widely accepted myths of passive investing to help fiduciaries in their
understanding.
Myth: Passive investing is risk-free.
Reality: Nobel Laureate Harry Markowitz observes: “Risk is risk.” Since there’s no
guaranteed safe way to reap the rewards of investing in financial markets, passive
investing is no panacea for escaping investment risk. Passive investing is, however,
the best way to rid a portfolio of as much uncompensated risk as possible (and the
only way of eliminating the risk of underperforming a given financial market).
But investing passively cannot eliminate the risk of losing money. No amount of
diversification–whether done on an active basis or a passive basis–can reduce the
compensated risk that’s present in all investment portfolios. That’s because such
risk is inherent in all financial markets. The only way to avoid that kind of risk is to
avoid investing.
Myth: Passive investing is investing just in S&P 500 index funds.
Reality: Many investors equate passive investing with investing just in S&P 500
index funds. When the stocks of the S&P 500 outperform some other well-known
asset class such as small-company stocks, they seem to think that passive
investing works. When those stocks underperform, many investors seem to think
that passive investing doesn’t work. The fact that the large-company stocks
composing the S&P 500 underperform some other asset class, though, has nothing
to do with the validity of passive investing. It just means that the stocks of that
asset class failed to outperform those of the other asset class for the period in
question.
Passive investing, then, means more than investing just in S&P 500 index funds.
For example, passive investors can invest in funds tracking the entire U.S. stock
market. Passive funds are also invested in small-company, midsize-company
stocks, and emerging-markets stocks that represent discrete asset classes. Other
passive funds provide the performance of asset classes reflecting specific
investment styles such as “value” and “growth” stocks. Nor is passive investing
limited to stocks. There are passive fixed-income funds that hold corporate bonds,
Treasury bonds, or combinations of them with clearly defined standards of quality
and maturity.
One of the reasons why passive investing is associated with the S&P 500 is that this
benchmark is the most widely used to designate the U.S. stock market. In addition,
the first index fund opened to individual investors tracked the S&P 500. At that time
in 1976, the S&P 500 was the only part of the U.S. stock market that was
sufficiently liquid to index. Since then, the U.S. stock market (as well as other non-
U.S. financial markets) has become much more liquid.
Myth: Passive funds lose more money in market downturns than active funds.
Reality: Evidence indicates that active funds do not avoid losses in market
downturns any better than passive funds. In fact, many active funds experience
losses larger than those of passive funds.
An active manager seeks to hold a greater percentage of cash reserves at market
highs, thereby exposing a smaller portion of its portfolio to declining values in
subsequent market downturns. (Passive funds, in comparison, are required to
remain fully invested so they are fully exposed to market downturns.) Conversely,
an active manager seeks to hold a smaller percentage of cash reserves at market
lows, thereby exposing a larger portion of its portfolio to increasing values during
subsequent market upturns.
There’s little evidence, though, that active fund managers have the foresight to
either a) hold more cash reserves before market downturns or b) hold less cash
reserves before market upturns. On the contrary, the evidence is clear that active
fund managers consistently hold smaller percentages of cash reserves at market
highs (thus exposing a greater percentage of fund assets to market declines) and
larger percentages of cash reserves at market lows (thus exposing a smaller
percentage of fund assets to market advances).
An example of such behavior occurred before, and subsequent to, the market
downturn of 1973-74. Just before that downturn, cash reserves of the average
active stock fund constituted just 4% of its assets. This illustrates the failure of
active fund managers to maximize cash reserves at market highs to minimize
losses when the market subsequently plunges in value.
Just when the market began to recover in 1975, cash reserves of the average
active stock fund stood at about 12% of its assets. This illustrates the failure of
active fund managers to minimize cash reserves at market lows to maximize gains
when the market subsequently soars in value. Note that the market gained over
37% in the first year of the subsequent recovery in 1975.
The fact that managers of active funds typically lower their cash positions during
market highs and increase them at market lows seems like just another form of
“buying high and selling low.” For example, in the summer of 1998 (just before the
largest stock market decline since 1987 up to that time), the average active stock
fund held cash reserves of less than 5%. These cash holdings were near all-time
lows, compared to cash reserves of 13%, close to all-time highs, at the market low
in 1990. Similarly, the average active stock fund held cash reserves of 12% of
assets in 1982, just prior to the beginning of the extended bull market of the 1980s
and 1990s.
The belief that passive funds lose more money in market downturns than active
funds, then, does not square with the facts. To the extent that passive funds do
underperform equivalent active funds in market downturns, such margins are
relatively insignificant (and transitory) when weighed against the substantial (and
ongoing) cost and tax advantages of passive funds in both soaring and falling
markets.
An active investor that holds, for example, cash reserves of 10% in a 20% market
downturn avoids two percentage points of loss. While this is advantageous, a
passive investor can save about the same amount every year (in both down and up
markets) because its portfolio costs and expenses are about two percentage points
less than the typical actively managed portfolio.
Myth: Financial markets would become inefficient if all investors became passive.
Reality: There are a number of reasons why it’s highly unlikely that this would
happen–at least within the next 1,000 years.
First, human nature ensures that many investors will continue to believe that they
(or someone they hire) can beat the market. The investment information system
has an enormous financial self interest in feeding and sustaining this belief. This
isn’t going to change.
Second, most money continues to be actively managed, despite the increased
popularity of passive investing in the 1990s. The amount of money held by passive
stock funds in that period inched up from only 6% to 8% of the money held by all
stock funds. If, after such a favorable period, passive investing couldn’t make any
greater inroads, then it’s difficult to understand how passive investing is going to
dominate financial markets.
Suppose, however, that reality was suspended and all investors suddenly became
passive investors. Once that happened, stock, and bond prices would begin to
diverge from their “true” underlying values. Note, however, what Nobel Laureate
Merton Miller says: “I know people will say, yeah, but if everybody invested
passively, who would discipline the corporations [i.e., ensure that corporate stock
prices are close to their underlying values]? Well, as I explained earlier, the few
people who are willing to spend the money to do it. And they will get enough extra
returns to compensate for their costs. But that’s about it.”
Who are those “few people” Miller is talking about? One group of people would be
managers of the companies that issue such stocks. Another group would be
managers of competing companies who are always faced with the question of
whether they should invest in more real resources (e.g., factories, machines, and
distribution networks) or just buy all the stock of the competition and take over its
real resources. A third group of people would be market makers who want to
ensure that stocks are priced efficiently. In a world where all investors are passive
investors, then, there would still be plenty of groups of people interested in making
sure that the market prices of stocks reflect their underlying values efficiently.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.