finweek

In response to critics of passive investing

Simon Brown, founder and director of JustOneLap.com.
Simon Brown, founder and director of JustOneLap.com.

Last year there was a much-heralded article comparing exchange-traded funds (ETFs) to Marxism, written by somebody who seemed to have a very loose grasp on both Marxism and passive investing. Now recently my inbox has been flooded with people sending me the link to another ETF-bashing article titled Has Passive Management had its Day? 

Broadly, both articles have the same theme, stating that, with the surge in interest and hence investments into passive instrument, we are distorting the market. The argument is that passive funds just buy the stocks within their benchmark without any consideration for quality, value or return. In contrast, active managers would carefully select the quality stocks, rewarding them as the buying sends those share prices higher, while selling the losing stocks, sending their prices lower. In short, the efficient market theory.  

Does passive investing distort the market?

The concern here is that with increased passive inflows, markets then rise with no consideration for quality. Without this consideration markets will just continue rising until there’s a fatal crash. Yes, you will note this is exactly what has happened repeatedly throughout history long before passive investing came along.  

Frankly, if 90% of inflows were into passive products, the few remaining active managers would have a field day because the theory is that these passive inflows would create a very inefficient market. This would make beating the market easy for the remaining active managers.  

However, the real story is that active managers who spend their days bemoaning passive investments and telling us how evil they are should rather focus on beating the market. The reason why passive investing has become so popular is because the active industry charges high fees and all the clients get are funds that mostly underperform the market. If active managers charged less and beat the market consistently, we would not be having this debate. It is the failure of active managers that is the problem, and blaming passive investors is just the easy excuse. 

Active managers have had their chance

For over a century, investment products have been active and one-sided in favour of these active managers and the industry. These active managers have not focused on the little person trying to invest their hard-earned money to ensure a decent retirement, nor have they performed well.  

For far too long now, investors have been sold horrid products with crazy fees that fail to perform. An example of this is the long-term insurance industry, which has divisions for closed products. These closed products are the ones they used to sell like mad back in the 2000s and earlier, although this is no longer the case. These were over-priced and under-performing nonsense products that in most cases turned out to be very poor long-term investments. Worryingly, the clients holding these horrid products are not being contacted by the industry with offers to switch into newer, better products; they just leave you in the stew.  

Passive managers must exercise their rights to vote

Another, but less frequently mentioned, criticism of ETFs is that passive managers do not bother to vote at annual general meetings (AGMs). Indeed, they don’t and this is a concern. But it is also an easy problem to solve in that passive managers could vote. The passive managers could make use of independent advice on how to vote and then vote accordingly.  

At the end of the day passive investing is still in its infancy and, as Mark Twain is alleged to have said when a newspaper published his obituary: “The reports of my death are greatly exaggerated.” I am confident the same applies to passive investing, and the active industry needs to stop complaining about passive and start working out how they can add actual value to investors, because so far their value-add has been modest at best 

This article originally appeared in the 23 March edition of finweek. Buy and download the magazine here.

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