DDIntel - Is Passive Investing a House of Cards?

Years of academic research all points to the same conclusion. The average investor can’t beat the market, so why even try? Why not invest in ETFs, close your eyes until retirement, and ignore the stress of timing the market?

Yet simultaneously, there seems to be a “formula” for beating the market that investors ranging from Buffet to Howard Marks, from Dalio to Soros, Simons to Jeremy Grantham have discovered. Could this all be due to survivorship bias?

Namely, be greedy when others are fearful, and be fearful when others are greedy. Reverse psychology, so to speak. The problem of course is that if everyone is fearful, that in and of itself can be self-fulfilling and justified. And no one wants to catch a falling knife.

So, is contrarian investing the key to beating the market? Is passive investing a Ponzi Scheme? Is passive investing built on a house of cards?

It’s not just that ETFs tracking market indices, such as SPY, are traded as if they are penny stocks. It’s that the parameters of what determines aggregate asset levels is fundamentally based on the Fed.

In other words, if the S&P 500 goes up or down in a given time period, in the short term, the direction of asset price movements can be predicted to a certain degree based on the level of hawkishness or dovishness relayed by the central bank.

When asset bubbles are clearly inflated and deflated by central bank easing or tightening, respectively, all investors have to ask themselves, is it even possible to be passive? Or is that in and of itself an active decision?

If passive investing is based on a house of cards and interest rates are a hammer when everything’s a nail, maybe what we’re witnessing is the real time and inevitable collapse of something built of paper.

This week’s DDIntel takes a critical, but fair look at passive investing. We open with value investor Thomas Herold’s article Passive Investing is Dead (According To The Greatest Investors). Paul Abela takes on the relationship between debt financing and environmental sustainability. Former NBA player Trevor Huffman writes about his experience on the relationship between passive investing and pro sports, while Ryan Dingler presents the academic case in favor of passive investing. Finally, Dr. Adam Tabriz argues that passive income is at least partially a myth.

Management Consultant and Value Investor Thomas Herold argues persuasively that the world’s top investors think passive investing is overrated. The world’s top investors pick stocks, not ETFs, because “Essentially, indexes (and ETFs) are built so that the bigger a company gets, the more an index will buy of it… The problem with this is that the bigger a company gets, the less it will also grow over the long term.”

There’s an interesting connection between the financial system and investment in sustainable technology; banks prefer to loan out to low risk sectors, so there is a short term bias against investing in unproven technologies even if their impacts would be positive for the world. As such, author Paul Abela argues that the financial sector is not only financially unsustainable, but environmentally so as well.

Former NBA player Trevor Huffman writes about his experience on the relationship between passive investing and pro sports. The key is to learn how to fail and how to learn from your mistakes. It’s okay to be different, and it’s okay to lose money if there’s a lesson involved.

We don’t want to present only one side of the argument; statistically speaking, passive investing is better than active investing (lower fees, better returns), as project manager Ryan Dingler points out. For example, over a 15 year period, the average active managed fund made 2.5% less than a passive fund. Furthermore, by definition trying to beat the market is a zero sum game.

Dr. Adam Tabriz argues that passive income is at least partially a myth. Very few people can actually earn a passive income, even though it’s everyone’s dream. The reason is that someone must work for the income, so little is left over for rent. Therefore, Dr. Tabriz concludes that “3rd parties” meddle in the process of earning passive income, leaving it elusive.