The Hidden Risks of Passive InvestingSubmitted by JMB Financial Managers on January 9th, 2019
It is no secret that investment dollars have been shifting from actively managed investments to passively managed investments. There’s one number that explains a good portion of this phenomenon: 5.52%. Over the 20 years ending in 2018, the nominal compounded annual growth rate (CAGR) of the S&P 500 has been 5.52%.
This low rate of return has given birth to, among other things, the rise of passive investing and the growth of exchange-traded funds. It has forced investors to manage costs and expenses to help offset the low returns and encouraged the use of automation to further reduce expenses wherever possible.
The Transition to Passive Investing
It is also no secret that investors have gone beyond merely shifting to a bevy of low-cost index funds and have moved millions upon millions of dollars into passive investment strategies and asset allocation models as well.
I believe many of these investors have done so on the basis of cost savings without understanding the long-term implications of their choice and could be in for long-term disappointment. For example, a 2018 research study prepared by the Natixis Center for Investor Insight revealed that 64% of those polled believe that index funds are less risky, and 71% think that index funds can help minimize losses.
What You Need to Know About Index Funds
In reality, index funds have no built-in risk management, and they actually become more and more risky the longer a bull market runs – which is the exact opposite of what investors believe. The most recent example of this would be the run up in the markets from 2000 until 2007 when the financial crisis hit. The S&P 500 Index – and all the index funds that follow the index – grew from 12.3% invested in the financial services industry to 22.5% due to the surge in popularity of these stocks.
Most investors had no idea that nearly one-fourth of their investment was in one industry and had no idea just how badly the financial crisis was apt to hurt their net worth. The same could be said for the dot.com markets of the late 1990s.
An Emerging Trend
The more worrisome trend, in my view, is the unwitting shift to passive asset allocation, and the more powerful effect this has on long-term investment results when compared to individual investment selection.
For example, in a landmark paper published in 1986, “Determinants of Portfolio Performance,” Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation is the primary determinant of a portfolio’s return, and in fact it was 90% of the reason for a portfolio’s return. The “Brinson Study” as it is referred to, was revisited by Gary Brinson in 1991 and yielded similar results.
A more simplified conclusion from the study is that 90% of the return in an investor’s portfolio will be determined by the mix of stocks, bonds, commodities, currencies, and cash and only 10% will be determined by which specific investments are chosen within each category, and the costs associated with purchasing them.
The returns by asset class in the past 10 years can be seen in the chart below.
Source: Nasdaq.dorseywright.com; W5000FLT represents the Wilshire 5000 Index; EFA represents the MSCI EAFE Index; DX/Y represents the US Dollar Index; AGG represents the Barclays Aggregate Bond Index; BJAI represents the Bloomberg Commodity Index. Investors cannot invest directly in any particular index, and the returns shown are not representative of any specific index funds.)
As you can see, it was far more important to own US Stocks (W5000FLT) and to avoid both Foreign Stocks (EFA) and Commodities (BJAI) than whether you had chosen a particular index fund. Yet, investors with a passive asset allocation strategy not only held a fixed amount of international stocks and commodities for the entire decade, but they bought more of them each quarter when they rebalanced their account, increasing their exposure to losses, and dragging 10 year returns down with them.
Investors need to spend more time understanding their asset allocation and investment selection in order to be prepared for the risks that come along with it. This will improve the odds of reaching their long-term goals and providing a basis for course corrections, as well as stick-to-itiveness when the time arrives.
*Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns and it is an investment strategy that will not guarantee a profit or protect you from loss.
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