Over the last decade or so, the flow of investments dollars into passively managed funds and out of actively managed vehicles have been an undeniable indicator of the rising preference for this type of investing. According to Morningstar, by the end of 2018, passively managed funds accounted for nearly 40% of all dollars invested in funds across the marketplace.
As defined by Investopedia, index investing is a common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long-time horizon. Passive investing refers to a broader investment strategy designed to maximize returns by eliminating extraneous buying and selling.
We note the difference as index investing is a type of passive investing, but there are many others and not all passive vehicles are created equal. Recently, Financial Planning magazine reported on the 20 worst passive funds over the last 5 years. I should mention that all 20 were ETFs, but that’s a different blog for a different day.
These investments aren’t particularly bad in their own right. Most are managed by large, well thought of money management firms. Firms that certainly don’t get into these vehicles to lose money, but they are making very narrow, very specific bets on a certain area of the market. Much like an individual stock picker, when investors or money managers purchase these vehicles, they sell themselves, and ultimately their investors, a story based on data, gut feelings or other analysis. Stories like…
Of course oil will go up.
Of course telecommunications companies are overvalued.
Of course Mexico or Spain or Norway or another country will outperform the broader market because of the political turmoil, trade talks, demographic changes, currency moves or any other reason under the sun.
And then the market does what it does. It can be fickle in the short-term, laughing at logic and throwing curve balls at investors.
Over these last five years, it seems the poorest performers were mostly betting on oil, silver, and other commodities. One bet heavily on Spain. Another on European banks. Still another bet against large U.S. companies. Regardless of the bet, over five years this speculation proved costly.
This, of course, isn’t limited to just these bets. These are the unlucky few this time around. Five years from now will likely bring us a new list of unfortunate losers.
The point is that investing in very narrow, specific areas of the market over any short period of time can be very volatile, even when passive in nature. The information one might think makes the bet obvious is known by all and is likely to already be priced into the investment being purchased.
Passive doesn’t equal diversified. Putting together low cost, broadly diversified portfolios with exposure to most of the market and then allocated between stocks and bonds in a manner that fits particular needs allows an investor to participate in the long-term growth of the broader market. As index investing and, by default, passive investing grows in popularity, it will become increasingly important to understand the differences between the two so that investors know what they’re buying and what kinds of risks they’re taking.