"Is passive investing really better than active investing?"
A letter from... Camille Thommes. The Director General of the Association of the Luxembourg Fund Industry (ALFI) warns against blanket judgments.
The European Commission recently published a paper arguing that private investors are best served by passive investment funds. These are more cost-effective, more broadly diversified and offer higher long-term performance than active funds.
Many investors seem to agree with this. Passively managed investment funds have grown at an above-average rate in recent years. In 2016 alone, the assets of passive funds rose 4.5 times faster than those of active funds, according to a calculation by research provider Morningstar.
Is passive really
better? The Commission's authors base their view on the market efficiency hypothesis of US economist Eugene Fama. It assumes that modern financial markets react quickly to new information and that prices always reflect all available information. However, private investors would have neither the time to follow the markets in real time, nor access to all market-relevant information - and thus no chance of outperforming the index. Even professionals would rarely be able to do this. At least not if fees and costs are taken into account, but sweeping judgments such as these should always be treated with caution. It is well known that there are no facts traded
on the stock exchange, but expectations regarding growth opportunities, future market position, earnings strength and profit prospects of a company. Active investors are constantly searching for the most promising industries and companies. They choose the most promising ones in order to generate the best possible return for themselves or their clients, and this can work - or not at all.
Passively managed investment funds, on the other hand, do not look at all. They merely reflect the stock index they have selected by investing exclusively in all companies represented in this index. The decisive factor is not earning power or growth opportunities, but only index membership. Index funds do not invest in up-and-coming companies that may become big one day, but in companies that are already big. They don't rely on the potential heroes of tomorrow, but rather buy the winners of yesterday,
so they can be quite successful, because these companies offer a certain stability due to their size, popularity and market position. However, index funds are also forced to buy a stock if it is already considered overvalued. For the same reason, they cannot sell a stock if their price goes down. I think that's a disadvantage.
And there's more of them. Often the investment spectrum is also quite limited, depending on the index. The DAX, for example, contains only 30 stocks. Forced investment in index values can also lead to concentration risks. For example, an ETF that depicts the Nasdaq 100 accounts for 41 percent of its assets in just five titles: Apple, Alphabet (formerly Google), Microsoft, Amazon and Face book. It is also
critical that the success of the ETFs has a procyclical effect. They always invest inflowing funds in the same shares and thereby drive their prices. An environment of generally rising share prices, as we have known for some years, automatically makes passive equity funds look good. However, if the market shown moves sideways and price gains of individual shares are compensated by price losses of other securities, the performance of an index fund is over. Meanwhile more and more experts are thinking about what will happen if the trend in the markets turns downward. Do ETFs amplify a downward movement? Are they even a systemic risk?
Passive is no better than active. It's just different. Private investors should take a close look at the advantages and disadvantages, examine the relevant indices and decide according to their individual investment objectives. Probably a combination turns out to be the most sensible variant.