Articles
Is passive index investing right for you?
This article has been a few months in the making, but it wasn’t until a comment from one of the readers that I realized it might be a good time to go ahead, finish it, and share it with you. The reader is a seasoned investor who worked with family offices on both sides of the Pacific, and his reaction to my recent article – Future-proof portfolio: does it even exist? – was: “How does passive index investing fit in the picture?” — So here are my thoughts on the topic.
A dear friend and fellow investor, Anthony Deden, shared (in an interview with Grant Williams from Real Vision) an anecdote about a conference organizer asking him for “a good investment idea or two.” Mr. Deden did not comply because he felt that it was like asking a doctor to write “a prescription or two” for medication without knowing a patient’s situation. He added that “an investment idea is worthless unless you understand whether it’s suitable to someone.” I couldn’t agree more.
In that context, people frequently ask me about passive investing in index funds that allow you to hold stakes in many publicly traded companies all at once. Like the appropriate dose of medicine, passive index investing can be a useful tool because it allows a large population to participate in stock ownership at a low cost and with even modest sums available to invest.
Interestingly, no one was bringing up passive index funds in the tumultuous years of the 2008/2009 financial crisis. Yet they were on people’s minds at the top of the longest-running bull market, and they are again now after this year’s post-March crash market rally. That’s an understandable phenomenon; investors often see index funds as a serious alternative to active investment management. However, they are not necessarily safe, reliable, consistent investment vehicles. Their results only do one thing, which is to track the market’s returns, desirable on the way up, but painful on the way down.
Disciplined investors — even “investment rock stars” like Warren Buffett — regularly underperform in the last leg of each bull market. Thus, an argument is made that there is no point in hiring a money manager since the free ride of the index brings good results all the way to the top of the market. It’s also true that some money managers chose to cautiously “hug” the index. In other words, their holdings closely follow the overall market, so as not to fall behind. In our opinion, index huggers are not really active managers.
Among truly active managers, a smaller group follows the disciplined approach of selecting stocks and holding them over the long run. In a way, what they do — and we count ourselves in this group — is very different from index huggers and index funds. We know exactly what we own and why. An index fund, on the other hand, will own a bankrupt or a fraudulent business all the way until its stock price drops to zero and gets delisted. It will also buy more shares of a company as shares become available to the public because insiders are selling. Also, index funds don’t shy away from buying shares of companies that are increasingly overvalued, and thus riskier.
Going back to Anthony Deden’s point about investment suitability, we have nothing against passive index investing per se if it’s used with a good degree of caution. The essential point lies in whether the investor or the client will experience a lifetime of contributions or distributions from your investment portfolio.
If you plan to earn, save, invest, and put a little bit of money away every month, a passive index fund might be a compelling option. You don’t have to time the market; you will dollar-average your purchases over the decades. (At times, you will be at a market low, at times at a market high, and it will be important not to overreact to those fluctuations.) Also, an automated contribution guarantees that you’ll invest no matter what the market does. History shows though that both mutual and index funds see record-high contributions at market tops (Source: FT, BlackRock attracts record inflows as the stock market soars, 1/15/2020), and record-high redemptions at market lows. This phenomenon makes the actual returns of average passive investors much less attractive.
If you are facing a lifetime of distributions rather than contributions, though, the story is very different. You might be living off your capital and collecting regular distributions to maintain your lifestyle, as many of our clients do. Their family fortunes, whether created recently or generations ago, play a very different role in their lives, and investments suitable for them might differ. It’s the money they can’t afford to lose.
If you were to put your entire family fortune or your nest egg in a passive index fund today, you would give up all flexibility and control. You would have to accept market returns, and in the context of the last ten-year bull market, that could still seem like an attractive choice. But if we face another “lost decade” in investing, it could be disastrous. Between the years 2000 and 2013, the S&P 500 saw both big sell-offs and big rallies, without any actual progress. (I mention the S&P 500 here because the top index funds in the U.S. track this broad market index.) The best possible outcome for those passive index investors who bought in in 2000 was to walk away with the same dollar amount after 13 years if they didn’t panic and sell out first.
It might be theoretically possible to invest passively on the way up, stay out of the market at its peak, and shift to active management as stocks tumble, but the simple fact is that nobody can time the market. What we at Sicart do instead is an attempt to capture the best of two worlds. We are value buyers and growth holders. We know what we own and why. We patiently wait to buy our holdings at attractive prices, and then we enjoy the rising market. When our holdings become expensive, we trim our positions gradually to avoid the worst damage from a possible sell-off.
Many observers see the recent proliferation of passive index investing as bad news. To us, it is the best possible news. The fewer truly active managers there are, the more money is passively invested, and the more opportunities there will be for the patient, disciplined stock pickers, who actually look at what they buy and pay attention.
No medicine’s suitable for everyone all the time. Similarly, no investment approach works all the time and for everyone. We believe that passive index investing is the right investment vehicle for those with small amounts to invest and those with a lifetime of small contributions ahead. For those with family fortunes relying on a lifetime of distributions, we believe that an actively managed portfolio — with all its flexibility and control — can deliver very respectable returns over the long run without running the risk of losing it all.
Happy Investing!
Bogumil Baranowski
Published: 9/3/2020
Disclosure:
The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”), and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector, or the markets generally.
The Standard & Poors 500, or “S & P 500” is market-capitalization-weighted index that tracks the 500 largest publicly-traded, United States companies.