THE DANGERS OF PASSIVE INVESTING
Global Financial Consultants
[vc_row css_animation=”” row_type=”row” use_row_as_full_screen_section=”no” type=”full_width” angled_section=”no” text_align=”left” background_image_as_pattern=”without_pattern”][vc_column][vc_column_text]All investors should be aware of the long-term wealth-building strategy of passive investing. Given the rapid increase in popularity of passive investing, it is prudent to explore passive investing in further detail. Passive investing provides heaps of benefits to investors, but it is not without its disadvantages and criticisms.
Passive Investing
Passive investing is a long-term investment approach in which investors purchase and keep a diverse range of assets with the goal of matching, rather than outperforming, the market. Passive investing is defined as a buy-and-hold approach in which the buying and selling off holdings in one’s portfolio are kept to a minimum. The most common passive investing approach would be to track a major index fund whose holdings mirror a major index, such as the S&P 500, or a representative segment of the financial market.
Cons of Passive Investing
Market Returns
As mentioned above, passive investing implies that the fund will invest proportionately to whichever market or index it is tracking. Therefore, it is unlikely you will get returns above the market/index. A market-cap weighted vs equal-weighted ETF might track the same index but have different performance figures. This accumulation of missed returns could be significant to achieving your long-term investment objective. This is especially so if you are investing during a strong bull market where a better asset allocation could result in returns above the market.
In addition, you could also miss out on potential additional returns if you have an investment manager with an established track record of outperforming the market/index.
Missed Opportunities
Given the nature of passive investing, one is not able to alter their exposure to individual securities in the midst of changing market conditions. This implies that an investor is unable to capitalize on desirable profitable positions. Therefore, investors are unlikely to experience the benefits of s strong price gain that actively managed funds can sometimes provide.
In addition, very often there are asset classes in which there are inefficiencies that lead to a discrepancy between an asset’s market price and its intrinsic value. An active investment manager would be able to identify and exploit these discrepancies.
Locked-In Capital
Passive investing go hand in hand with long-term investing. They complement one another for an effective investing strategy. This is because the nature of passive investing requires earning returns over a long-time horizon. As a result of the locked-in capital, an investor is unable to use this capital elsewhere should other attractive opportunities arise during this time.
Buying ‘Blind’
A passive fund buys the market and therefore often buys ‘blind’ without considering the worthiness of the underlying investment. This could be an issue, particularly, if a company that makes up a high percentage of the fund turns out to be a bad investment. On the contrary, an active manager would have realized that this is a bad investment and would have reacted accordingly to opt-out of the investment.
Inability to React to Market Changes
Should a negative impact event occur which negatively affects the market, a passive fund will still continue to hold onto the market/index. There is little to no ability to disinvest to reduce downside risk or invest more to take advantage of a temporary fall in investment. Even if an index fund manager predicts a market correction or a decrease in the performance of the benchmark, they are very often limited in their ability to react accordingly. Index fund managers are not able to take steps such as cutting back on the numbers of shares they own or take an appropriate defensive counterbalancing position in other securities.
Lack of Exposure to Small-Cap or Illiquid Stock
Due to the fact that many indices concentrate on large-cap or liquid stocks, passive investing results in foregoing opportunities in small-cap or illiquid stocks. These investment opportunities can occasionally lead to higher returns.
To achieve high returns over the long term, you can’t just invest in the market averages and expect big returns over time. Long-term outperformance necessitates, among other things, a significant allocation to individual growth equities and specialized ETFs with fundamental upside.
Liquidity Concerns
ETFs are prime instruments for passive investing and reflect valuable information about the true state of liquidity in the markets. This is primarily due to the demand and supply in the secondary markets, along with the authorized participant’s role in arbitraging the difference between the net asset value and prices. Usually, this results in low tracking errors, however, this may not always be the case. Especially during the turmoil in the markets.
In the event of a severe market downturn, even seemingly liquid ETFs could experience liquidity risk. The money is distributed across the securities in the index via passive index funds. In certain circumstances, the vast majority of the stocks traded are those with low volume and low value. Therefore, as AUM increases, there is a risk that a portion of the index may not be liquid enough to sustain any extreme selloffs.
In which case, the tracking error could widen and cause several issues. In the downturn of March 2020, roughly 70 fixed-income ETFs were trading with at least a 5% discount to their NAV while 16 traded at a discount of 10% or greater. This directly suggests that some of the ETFs will not function as a steady, index-based product during crisis-like periods as previously thought.
The Bottom Line
Passive investing has several benefits backing its quick rise that has been changing the investment landscape. Despite heaps of its benefits, some of the embedded issues of passive investing have only started to surface lately.
As a result, the best investment strategy is a blend of active and passive investment strategies. It doesn’t have to be an either/or choice. The ideal approach entails an active investment management strategy while prudently incorporating some facets of passive management to gain exposure to specific areas of the market. Combining these two strategies can help to further diversity a portfolio, manage overall risk and increase returns.
Deepak Singh is an Authorised Representative of Global Financial Consultants Pte Ltd – No: 200305462G | MAS License No: FA100035-3
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General Information Only: The information on this site is of a general nature only. It does not take into account your individual financial situation, objectives, or needs. You should consider your own financial position and requirements before making a decision.
*Please note that Deepak Singh is not a tax agent or accountant and none of the content outlined here should be taken as personal advice. You should consult your tax agent and financial adviser to review your current personal finances and financial goals to consider whether this strategy is appropriate for you.
References
https://www.businessinsider.com/passive-investing
https://www.investopedia.com/news/active-vs-passive-investing/
https://www.fool.com/investing/2021/02/25/4-simple-steps-to-beating-the-market-in-2021-and-b/
https://thewolfgroup.com/blog/why-passive-investing-should-not-be-your-only-investment-strategy/
https://www.investopedia.com/epic-shift-sees-passive-funds-pass-active-as-stock-pickers-retreat-4769887[/vc_column_text][/vc_column][/vc_row]