The Passive Indexing Pain Point And How To Reduce It

by: Jonathan Selsick

Summary

The evidence in favor of passive indexing is getting louder and more convincing, particularly with the help of the robo advisors who use this as their primary sales pitch.

We explain graphically the mechanics of active versus passive in layman sports terms.

Passive indexers are guaranteed to participate in 100% of the draw-downs. Our disproportionate aversion to loss versus gain, makes this painful - especially if making regular withdrawals from your account.

We offer guidelines to minimize this pain and for selecting an active strategy if you should choose to.

The Evidence is getting louder

The number of articles discussing the futility of active investing seems to have increased exponentially lately.

It is true, that in aggregate, after fees, taxes and commissions, it is theoretically impossible for all active managers to beat the index. Furthermore, the evidence shows that only a miniscule percentage of managers have outperformed the index consistently over long periods of time, and even this could still be explained by luck!

Vanguard has always promoted low cost indexing as their core philosophy, but lately so many money managers, especially the robo advisors, are beating this drum to help gather assets under management. It's working - robo advisor assets are growing like crazy. Even the giant CalPers is giving up on hedge funds and cutting back on active managers.

While the evidence is convincing, it represents a defeatist attitude - you can't beat passive indexing so just give up trying. But, with access to more data nowadays, we have the ability to develop active solutions that better model the complex interaction between the real and financial economy.

It's like a soccer game

In our diagram below, there are two ways to participate in the game - active or passive. The active team is represented on the left hand side and the passive team on the right hand side.

Active

Every day the markets are open, portfolio managers are out on the field competing with each other to score goals. The players in green are the winners and the players in black are the losers.

As an investor, you have a choice; if you want to field an active strategy, you approach an advisor or money manager who will send one of her portfolio managers onto the field. This is not free of course. Next, every time his portfolio manager touches the ball, you pay a small commission to the field attendant (the broker) for keeping the field tended. The more times your portfolio manager touches the ball, the more you pay. Finally, if your portfolio manager scores a goal then there is another fellow by the name of Uncle Sam who steps onto the field to collect his cut of the action. At the end of the game, the players walk off and distribute what is left back to their supporters - you the active investor. You earn the difference between the green team goals and black team goals, less any payments to the three constituents on the left who make the game possible.

Passive

The referee (the passive index provider) will let you watch the game, and will allow you to bet on team green beating team black, without any fees being sucked out by the game organizers on the left. You don't have to worry about finding good players and paying them to work; all you need to worry about is that the green team beats the black team - simple. Seems like a great deal, right?

There's only one other rule, you need to sit through the whole game regardless of who is winning - you cannot get up and leave if the black team is winning and you are losing money, regardless of how bad it gets or how long it goes on for.

This is the pain point we are talking about. Can you hang on through the entire game? If the green team wins, you are happy. You don't really care that some active investors may have correctly picked the high scoring players and made more than you - you made some money and are better off than before. But when the black team wins and you lose, it doesn't make you feel any better that some active investors lost more than you. This is a well-known phenomenon that pain and gain are not equally offsetting emotions - we feel pain more than we enjoy gain.

How Bad Does it Get?

A lot depends on your time frame. If you are young and have a long career ahead of you, you have time to allow your portfolio to recover and can make adjustments to your human capital plan (your work) to offset any pain. On the other hand, if you are already in retirement and have exhausted your human capital and are making regular withdrawals from your account every month, you will feel the pain more intensely.

I reality, the markets have only been in drawdown mode for about 15% of the time over the past 50 years, so it doesn't happen that often, but when it does, it's painful, and one never knows whether this drawdown is different from all the previous ones and may last much longer. The media have a way of highlighting the negative so the pain gets accentuated and the worry builds. And of course, to recover from a 50% decline requires a 100% recovery to get back to even.

Plan Essentials

There are a couple of things you can do.

  1. Make sure you have a plan for how you will cover your living expense when there is a downturn. You should have enough for five years to be on the safe side, if you are already retired. If you are younger, one to two years is probably okay, since you should likely find another job in that time period.
  2. Have a well-balanced and diversified strategic asset allocation. There is a lot of skill in getting this right and you should think carefully about your circumstances. You want to be diversified to the major drivers of asset returns - namely economic growth and inflation. Decide whether you want to overweight one of these factors based on your outlook for the long term. This may be your most important decision - consult with an advisor or do it yourself, but take the time to think it through.
  3. Re-balance. This is essentially selling high and buying low. This can be done on a calendar basis (quarterly/annually) or based on a market metric such as valuation. Try to keep turnover low to avoid taxes but still maintain a balanced exposure.
  4. Valuations are important. Drawdowns are caused mostly by economic contractions or once in a while by black swan type events. As long as valuations were not in bubble territory, you can ride out the drawdowns with less stress.

This is your basic groundwork whether you are a passive or active investor. Stick with the plan.

As a side note, we should clarify that even passive indexing is not actually passive. The index changes according to changes in its constituent's cap weights. New, growing companies enter the index and old laggards are removed. Truly passive would be buying the same stocks and holding them forever. So even passive indexing is an active strategy.

If I still want to be active, what should I do?

The dilemma of active investing is that only a few of the green players will perform well in any given year - how do you know which ones to pick?

The two primary types of active strategies are stock picking and market timing. Since we are focused on avoiding the drawdowns, this is more likely to be accomplished with a successful market timing strategy than a stock picking strategy - the stock picking strategy has more chance of beating the average in up markets, but the timing strategy has more chance in down markets.

What to look for in an active strategy

  • Focus on systematic (rules-based) non-discretionary strategies. Process is perhaps more important than past results.
  • Make sure it has been tested on long data sets covering many economic cycles - not just the last 10 years.
  • It should not be based exclusively on technical indicators. There must be a logical cause and effect to the variables in the model. It should have a reliable valuation component and a good risk measuring component.
  • Is there a track record, or is it based on a model with hypothetical results? Make sure you look at average annual returns, not compound returns which can be heavily influenced by start and end dates, since that can be very deceptive. Look at Sharpe ratios to see how much risk was encountered to achieve those excess returns.

A formula for evaluating the cost benefit of active strategies

It's a simple business decision. There is a cost to sending a portfolio manager on to the field and there's no guarantee that he will be successful. Your expected returns should therefore compensate you for the added expense and risk of participating, otherwise you are better off sitting on the sidelines for basically free, and accepting the outcome.

Our rule of thumb -

  • If the manager has a real track record of performance, then the excess returns over the passive index should be at least two times the fees you are paying. For example, if you are paying 1% more in fees for the active strategy, it should have outperformed the benchmark by at least 2% historically.
  • If the strategy is based on a back test, then increase that to three times, or 3%.
  • If it's a black box strategy that you don't have any insight into, then perhaps an even higher hurdle rate.

In all cases, be sure that excess returns are not the result of taking on more risk, so look at sharpe ratios too.

Lastly, don't put all your money with one manager. Diversify your sources of alpha. There is no silver bullet - whichever approach you choose carries risk.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.