OBJECTIONS OVERRULED

It’s often I’ve either uttered the phrase myself or heard others say, “What did we ever do before _________?” You can fill in the blank with any number of items: computers, e-mail, cell phones. They’re all things that seemed revolutionary and obscure at first, but quickly became a part of everyday life. We were fine doing things the way we always had—dropping a letter in the mailbox, stopping at a pay phone to make a call—until we realized something easier, faster, better was available. Each new development also became the standard. “You don’t have a cell phone? Wow, I don’t know how you do it.”

One of the most revolutionary and, unfortunately, most resisted methods in the investing arena has been passive investing. Whether indexing or asset class investing, many look at passive investing as something that won’t hold fast. We often hear from those resistant to embrace it and have found that their objections don’t really hold water. Let’s consider a few of the popular ones.

1.   It’s really just a fad.

It’s not unusual for a new idea to take a while to catch on with the masses. There were those that ran out and bought DVD players, for example, as soon as they hit the market, while others held back, not wanting to invest in new equipment, only to be left with something obscure if the idea didn’t catch on.

However, passive investing has roots back in the 1960s. Research began finding anomalies in the market and throughout the 70s and 80s, interest and research in the area of passive investing slowly gained ground. It became “mainstream” in academia in the early 90s when Kenneth French and Eugene Fama published their work on the effects of the small cap and value asset classes. Passive management is decades old.

Consider other “fads” from the 60s and 70s: the laser, the pocket calculator, the personal computer. Sure, some things come and go (who’s still got their Pet Rock?), but anything that stands the test of time for decades has proven its staying power.

It’s those decades of staying power for passive investing that provide proven results. Results that, yes, may be catching the attention of return chasers who have begun jumping on the bandwagon, but results that have years and years of science and economic study behind them. Passive investing is not going anywhere.

2.   It only works for large-caps.

Large-cap stocks (the big blue chips) are where most investors tend to hang out. Those are familiar stocks—Coca-Cola, Microsoft—that people are comfortable having in their portfolios. The argument that passive investing works only for large-cap stocks makes the assumption that because there’s so much more activity and research information in that asset class, prices are more efficient.

If that’s the case, let’s consider the converse. With activity so rampant in the large-cap stocks, that leaves less activity to be done in small-cap stocks. If it’s true that the volume of activity in the large-cap arena ensures that asset class’s efficiency, then small-cap stocks, with much less activity, would then be less efficient.

But, as all stock pickers know, inefficiencies bring opportunity to investing. So, with all of its supposed inefficiencies, the small-cap stock pickers should be blowing their indexes out of the water. Is that happening? Not hardly.

Consider U.S. Small Cap stocks over the past 10 years. Of the mutual funds still in existence, only 25% were able to beat their small cap index. International Small Cap tells the same story. A mere 18% of mutual funds beat their index over the last 5 years. That doesn’t include all of those that were closed due to poor performance.

If passive investing worked only for large-caps stocks and the small-cap asset classes were left with numerous inefficiencies, those percentages would be more than 50%.

So this objection is put to rest by knowing that more activity does not more efficiency make. The market, with all its asset classes, efficiently sets prices, making it (all of it) a perfect environment for passive investors.

3.   It only works in bull markets.

If the argument is that passive investing works only in bull markets, the implication is that in bear market periods, active management (or abandoning the market all together) is the way to go.

If active management is the way to go in bear markets, let’s look at the last bear market period, from 2000 to 2002. During that time, in the Large Value asset class, only 21% of managers outperformed their index. For Large Blend (considered by many to be the most efficient asset class), there were only 28% that outperformed their index. Not too convincing. Let’s look at the other alternative.

If bear markets were the signal to abandon ship and leave the market altogether, you would see the smart managers getting out at the right time and back in at the right time, thereby avoiding downturns and beating the index over time. We all know that doesn’t happen.

Yes, passive investing works in bull markets. However, it also works, it especially works, during bear markets. Need convincing? While the Dow Jones lost 13.09% from March 1, 2000, to October 31, 2002 (our last bear market period), and the S&P 500 lost 32.71%, the 100% equity Market Return Portfolio model lost only 8.95% during the same time. Add in some fixed income and you see the 80:20 model (80% equity, 20% bonds) losing only 3.18% and the 60:40 model gaining (yes, gaining) 2.67%.

4.   It’s a self-fulfilling prophecy.

A self-fulfilling prophecy is a false definition that spurs new behavior that ultimately makes the false statement become true. What’s implied by this objection is that passive investing is an inefficient theory, but that it will peak the interest of enough people, who, when they start practicing it, will make its efficiencies come about. Everyone will begin buying indexes and asset classes, the theory goes, and eventually drive up their value, which will give them the success they say is inevitable.

Consider this: In the 1990s, the S&P 500 was the belle of the ball. A lot of investors adopted the indexing practice and the price of the index was driven up. However, that’s just one piece of the market and it’s a piece of the market that collapsed when the tech bubble crashed.

However, asset class investing, the pinnacle of passive investing, contains all of the market, not just one small portion. So in order to become a self-fulfilling prophecy, it would require that people rush in to every part of the market at once. And, in a sense, that does happen. Markets go up over time because prices are driven up by numerous factors, things such as efficiency, productivity and population growth. But that’s the whole market.

We suppose that in some way, capitalism is the self-fulfilling prophecy that makes successful passive investing possible. But remember, a self-fulfilling prophecy begins as something false. There’s nothing false about our free capital markets. They have stood for centuries and are the very foundation upon which this country rests. If there are those that want to hold out for an implosion of the system, they’re going to be waiting a long time.

5.   What about the tech bubble?

The tech bubble saw investors lose money almost across the board. It was a typical bubble situation and when the bubble burst, there were few that were left unharmed. However, there were some that were harmed much less than others. Consider that our Market Return Portfolio models lost significantly less than their actively managed counterparts (or even gained). The numbers are outlined in #3.

While many try to use the tech bubble as a reason not to passively invest, it’s actually one of the most compelling cases for doing just that.

6.   What if everyone indexed?

What if everyone wore a seatbelt? What if everyone stopped smoking? Undoubtedly the world would be a safer, healthier place, but it will never happen. People are human and, as a result, continually give in to tendencies that may not be in their best interest. Investing is no exception.

According to John Bogle, founder of The Vanguard Group, only about 15 to 20% of investors are currently utilizing passive investing methods. That’s twice what it was 10 years ago. There’s no question the practice is growing, especially with institutional investors, as well it should in any fiduciary environment.

However, despite that growth, there will never be a time when all investors are passive investors. There will always be those out there (CEOs, analysts, overzealous do-it-yourselfers) who will take risks and invest in individual stocks, either because they don’t know better or think they are better. While the ideal situation is that passive investing becomes more dominant, for the individual investor’s sake, active management will never completely disappear.

So, just as those who find themselves arriving late to the Internet or wireless age are often questioned on how they survive without the latest modern conveniences, the same, we’re confident, will one day be asked of active investors. While to many, passive investing seems revolutionary and out of the ordinary, it too, we’re sure, will in time become the new standard. “You’re still picking stocks and trying to time the market? Wow, I don’t know how you do it.”

 

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