A Better Way to Actively Invest, Part 2 of 3
We follow up last week’s discussion (Part 1 of this article) on the pros and cons of actively managed mutual funds with one discussing the merits and weaknesses in passive/index investing in the stock market (mention of “passive” or “index” investing below specifically references the stock market) .
Passive Investing is a Good Option for Many But Not a Panacea for All or Even Most
We don’t have to tell you that passive investing is a very good option for those seeking diversification and growth but are still sensitive to costs (including taxes). The rise of exchange-traded funds (“ETFs”) has made passive investing easy and cheap to execute. Passive investing has also outperformed most active mutual fund offerings over the past decade (as mentioned in Part 1 of this article). However, despite the attractive benefits and good performance, we don’t believe passive investing represents the best investment choice available to everyone or even most investors.
There are downsides or short comings to passive investing. Although generally perceived to be low in cost, passive investing has real and tangible costs and may not be as efficient as one might expect. Even the lowest-cost index fund or ETF has explicit costs (i.e. expense ratios) and suffers from tracking error (i.e. performance differences from the index they are trying to replicate) as low-cost ambitions outweigh accuracy. These “costs” resultantly lead to trailing performance relative to the benchmark index. In other words, actual or real-world passive investing inherently involves costs that result in poor returns relative to the actual, underlying benchmark (the difference is admittedly small in size but trailing nevertheless).
The promised benefits of passive investing fail to materialize for many investors. Low costs, diversification, tax efficiency, and an implicit avoidance of active management risk are common benefits connected to passive investing. However, we believe these goals are illusory for many passive investors. Many investors employ the services of an investment professional. Investing passively through an intermediary generally negates the cost benefit as an extra fee layer is introduced. To be sure, mutual funds can also be purchased through the help of an investment advisor, making them an even more expensive proposition. However, proponents of mutual funds aren’t claiming them to be low or no cost, and their goals generally aim to add value on an after fee basis (something passive investments can never do). Passive investors employing an intermediary are also essentially paying for portfolio diversification which should ideally be free. Further, if that investment professional makes tactical decisions, shifting between markets or sectors in an attempt to add value, they are engaging in active investment management and adding risks to your portfolio (the same is true of market timing schemes undertaken by the home/direct investor). This is fine for those who are looking for this kind of service, but investors should understand that they are no longer investing passively and accruing the associated benefits. This form of active management adds a layer of costs, increases potential tax liabilities, and introduces active risks to a portfolio of passive investments.
Passive investments generally share the characteristics of the market they are designed to emulate. If the stock market is volatile, then so will be the index fund or ETF used to obtain that exposure. Investing in stocks, passively or otherwise, means implicit acceptance of the inherent volatility in stocks (many investors may not fully understand this). And that volatility is not constant. The stock market is not efficient and there will be times when the level of stock market volatility (a symptom of market inefficiency) increases dramatically. If you are invested passively (through an index fund or ETF), or even in a more concentrated “enhanced” index portfolio of stocks that adheres to a “buy and hold” philosophy, you will also experience similar levels of volatility. If the market enters into a long-term period of sub-par growth or experiences negative returns and higher-than-normal volatility, your investment portfolio may experience the same (assuming you stick to the buy and hold plan). If you are nearing retirement age or currently are in retirement, that may not sound too appealing. Again, all investors in stocks regardless of whether they use a passive or active investment strategy must cope with volatility. However, passive investors alone have voluntarily locked themselves into a flight path similar to the market’s and have chosen to forgo opportunities that might otherwise achieve an outcome different to the index.
We have long suspected that most investors are well behind the curve of saving and planning for their retirement. Only 5.5% of investment households in America are considered to be of high net worth with at least $1 million in investable assets; another 5.5% are considered affluent with between $500k and $1 million in investable assets (if you consider these labels of wealth to be accurate). The remaining investors potentially run a serious risk of outliving their wealth if they don’t have a few decades in between them and retirement. Many investors underestimate their life expectancy and therefore their expenses and financial needs in retirement. They also generally underestimate their need for growth assets and the opportunities provided through active investing.
As such, we are dubious about the investment merits of passive investing for the many investors that are behind on their retirement planning. These investors run a real risk of outliving their wealth. Unfortunately, the reality is that many investors and households fall into this category. Passive investing is a generic investment tool designed for the masses. The benefits that they promise are sufficient for many investors. However, every investor is different in terms of needs and circumstance and their goals and proximity to retirement can vary tremendously. Passive investing is no panacea for the millions of investors or investment households that need extra help. Passive investing does not help investors maximize their wealth generation potential as it ideologically shuns the potential value add of active investing. Essentially, this leaves money on the table. For the many investors that fall into the category of being late or behind on retirement planning, they cannot afford to play it safe (if we can call it that) with passive investing, especially if the opportunity to do better exists.
Passive investing has been tremendously helpful to investors who require market participation and have focused on minimizing fees. Unfortunately, many other investors find themselves in the less-than-advantageous position of being behind in saving and planning for their retirement. For these investors, the risk of outliving their wealth is all too real. We believe these investors need to maximize their wealth generation potential to make up for lost time. Active investing is one of the levers these investors can utilize to help them avoid outliving their wealth. We generally believe mutual funds are poor investment vehicles. But another method of obtaining active investment management exists that has been readily available in the past to more affluent or high net worth investors. We think its well past time for other investors to gain access to direct stock investment management. Please watch out next week for the 3rd article in this series to find out more about this opportunity.
Please tune in next week for part 3 of this post.
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About Belleros Capital Management:
Belleros Capital Management is an independently owned investment management and advisory firm serving investors who have a desire to embark on an investment strategy that will help them reach their long-term investment and retirement goals. Our primary purpose is to help investors reach their financial goals through a plan to minimize the “all-in” investment-related fees they pay, increase the value-add they receive from their investments, and by working with them to develop a strong level of investment discipline that will help them maximize their wealth generation potential.
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Investment advisory services are offered through Dover Road, LLC; a Maryland registered investment advisor doing business as Belleros Capital Management. This post is not to be directly or indirectly interpreted as a solicitation of investment advisory services to residents of another jurisdiction unless the firm and the provider of this document is registered and/or licensed in that jurisdiction, or as otherwise permitted by statute.
Investing involves risk including the potential loss of principle. No investment strategy can guarantee a profit or protection against loss in periods of declining value. Past performance does not guarantee future results. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.