March 5, 2018

The Pitfalls of Passive Investing

When market returns are attractive, as they have been for the last several years, the lure of passive investing is strong. After all, who wouldn’t want to capture market returns when the market is booming? (Passive investments, or index funds, closely mirror indexes in order to provide investors with broad market exposure at a generally lower cost than actively managed funds.) Passive investing can serve a purpose in a portfolio, particularly in more efficient asset classes, but investors should be aware of the pitfalls of overusing passive investment strategies, as outlined below.

With passive investing, a market downturn can hit hard: Any market correction will likely have an impact on all investors no matter how they are invested. But one of the advantages of active investing is that active managers are able to cushion the blow of volatility by positioning themselves defensively and making tactical moves within portfolios to take advantage of opportunities resulting from a correction. A passive fund must simply absorb the full impact of a market downturn.

Passive investing bets on the big guys: A passive approach is a bet on the largest companies, since those are the firms that typically have the most significant exposure in an index. That’s great during periods when FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks and other giants are dominating, but the economic environment rarely favors the same thing for long. Active managers are able to seek out and identify companies that are poised for success in any given environment.

Average may not be enough: After eight years of strong returns, investors are starting to expect the same high rates of return indefinitely. But when the cycle shifts, long-term expectations may have to adjust as well. When that happens, will the market return be enough to meet investors’ goals? Active management uses skills, knowledge, and experience to carve out an edge over the market, but for passive investors, the market return is the upper limit. Consider your long-term investing goals, and whether a market return will be adequate to meet them over the long run.

Passive investing misses on sustainability: Morningstar recently began assigning sustainability ratings to mutual funds and ETFs based on the environmental and social governance policies of the holdings companies. Many index funds fall in the bottom half of their peer group rankings, as they represent a relatively unmanaged list of stocks. For investors who are looking to have their investments reflect their values, active investing can better take into account social and values-based concerns and objectives.

The market environment of the past few years has been nearly ideal for passive investors, with strong overall returns dominated by the largest companies. But investors should not be lulled into believing that this environment will last forever. For a long-term investor, passive investing may be an important part of a portfolio — specifically in the most efficient asset classes where information is abundant and securities are generally fairly priced relative to one another, such as U.S. large cap — but we suggest that it may be best used in conjunction with active management in less efficient asset classes (including, for instance, international and emerging markets, small cap, etc.). An active investment strategy can offer significant advantages for long-term investors, and the potential higher cost is irrelevant if the net-of-fees return over time is higher.

Of course, not all active managers are alike, and thoughtful, careful manager selection can make all the difference in the success of an active investment strategy. This is where Arnerich Massena comes in. Our long-term success in selecting active investment managers is a significant differentiator in our clients’ portfolios. Let us help you avoid the pitfalls of passive investing with our world-class active manager research and selection process.