You will never get rich investing passively. Not in the markets, not in life. No person who has ever made a significant profit in the financial markets or impacted the world has ever woken up in the morning and said, “I want to be mediocrity.” This does not happen in life.
Sure, there are plenty of rich passive investors, but passive investing isn’t the main driver of wealth, it’s how much and how early you invest. There is no secret passive investingbut money, time and compound interest.
Over the past twenty years, tens of trillions of dollars have gone into passive investment strategies at the expense of active managers. In fact, by the end of this year, passively managed classic mutual funds and exchange-traded funds (ETF) in the United States will exceed the money managed by active portfolio managers. This means that more than half of the $25 trillion in capital will go into predetermined index funds without a second thought and regardless of valuation or technical parameters.
Before we continue, let’s clarify the terms. Passive investing involves a low-cost investment fund (investment fund or ETF) purchase representing a selected index, e.g. S&P 500 stock index or Bloomberg Barclays Global Aggregate bond index. Their costs are low because they don’t employ teams of well-paid portfolio managers and analysts, and they don’t have the significant distribution costs of typical active mutual funds. Instead, they simply pay a license fee to the index provider and hold the securities included in the index. They adjust their investments whenever the proportion of the underlying indices changes, which may be quarterly or less often. It also reduces trading costs.
Actively managed funds are managed by portfolio managers who use a variety of valuation parameters, research and market timing to select investments that they believe, after receiving a commission, will outperform the index they have chosen as a basis for comparison.
Active fund managers used to have a great life. In the second half of the last century, as capital volumes grew, more and more money flowed into fund managers’ portfolios. There was no better alternative for a professionally managed, diversified investment product that could be invested gradually. Mutual fund trading boomed.
Essentially, these companies were tasked with being good asset managers for their clients, but there were multiple levels to the game. The top-grossing mutual funds made huge investments in marketing and raised hundreds of millions, if not billions, of client money. Elite managers like Peter Lynch were worshiped like rock stars and became household names. They were also treated as special VIPs by brokerage firms that wanted to capture their trading revenue. No funds were spared. Everything was quite simple – a happy customer meant a lot of commission. I still remember when I was interning in the institutional equity trading team of a world-class bank, the head trader told me that he had just visited clients in Texas and they had spent $70,000 shooting all kinds of guns.
The mutual funds sold promises of future profits, while as part of this arrangement they restricted the movement of their clients’ money for up to seven years through deferred sales commissions. These commissions allowed fund companies to generously reward top sales professionals with extravagant prizes and pay packages for achieving the highest percentage targets. Everyone was making money. It may seem incredible to passive investors, but the clients of active investment funds themselves also made money. It turns out that investing money for a longer period of time, rather than jumping from one investment to another, was actually very beneficial for mutual fund holders.
Then in all this euphoria and something happened to the joy of making money – it was disrupted by capitalism and innovation.
On December 31, 1976, Jack’s company Vanguard launched its first index fund. At first he was ridiculed – no one could imagine how he could make a profit. However Vanguard assets under management continued to grow, although it took more than 25 years for investors to really take an interest in these products.
Until then, asset managers did not take the threat of passive investing seriously. Of course they were tied to the indexes, but if no one could buy the indexes, then all they did was compete with each other. In addition, even if the fund did not regularly beat its index, the fact that new investor money was half-frozen for seven years meant that every now and then there would be a good period of returns where a lot of new investor money could be attracted again.
But it wouldn’t hurt for asset managers to pay more attention to the theory of passive investing, as proponents of passive investing began publishing research showing that high commissions (“Everybody was doing it!”) and current data on historically actively managed mutual funds (“We didn’t know that someone will compare!”) resulted in over 75% of managers underperforming their index. When these studies were published, the dangers of passive investing were already clear enough.
Fortunately for asset managers, many investors tend to be complacent. With this in mind, managers changed strategies. The game was no longer about beating other managers; now the threat came from losing the index. Therefore, many major managers engaged in hidden indexing (closet indexing). This means building portfolios that essentially mirror the index with small deviations in the relative weights of individual positions, which supposedly ensures that your performance will never drastically underperform or outperform your chosen index. But you can still charge great management fees while your marketing team works hard to convince clients that you have an extremely talented manager at the helm of your portfolio who can keep you out of harm’s way if the indexes do something catastrophic. It also worked very well for a while.
And then something that really happened – the great financial crisis. And only a few actively managed funds actually avoided the danger. That’s when real money started flowing into passive strategies, and this coincided favorably with the low rate policies of developed countries. Free money, which was invested in index strategies, was a real victory for passive investors. However, let us remember that the triumphant Roman generals were followed during their victory marches by slaves whispering: “Memento mori!”
The Romans liked to celebrate their military victories, but they were well aware that overconfident generals could threaten their republic. It was necessary to strive for success, but too much self-confidence could destroy all previous achievements.
Passive investing has been a very successful strategy since the Great Financial Crisis, but all strategies come to an end, all empires fall. And not everyone who competes with passive investing is resigned to defeat.
I recently attended an investment conference in London hosted by one of the world’s leading asset management companies Schroders. They are acutely aware that their existing business model is under threat and are ready to fight.
Faced with a monolithic opponent of passive investing, they emphasize leadership, both in terms of identifying critical investment themes and in their role as responsible capital managers to help steer portfolio investments toward a sustainable future. They also position themselves as favorable key holders of private asset funds (private equity, private loans, venture capital, and the like) for new investors who would not be able to participate in such investments themselves because they are not managing hundreds of millions or even billions of dollars. Namely, the characteristics of private investments make them unsuitable for passive investment products.
This is done during when passive investing has contributed to the loss of balance in the major stock indices. For example, in the seven largest S&P 500 more money has accumulated in index companies than ever before. As a result, despite declining revenue growth, very high valuations have developed. Excessively high earnings multiples are not an ideal predictor of future profitability.
Moreover, until now passive investors have prided themselves on diversification, but how can one claim diversification when only seven companies account for nearly 30% of S&P 500? The combined market capitalization of the seven largest members of the S&P 500 index is nearly $11 trillion. This amount is greater than the market capitalization of all Chinese publicly listed companies ($9.5 trillion).
Is active management about to make a grand comeback against passive strategies? Time will tell. But the next decade certainly promises to change investing as we know it today.
2023-11-24 04:37:41
#successful #investor
