Passive investors and bubblesPosted on: 10 July 2017 by Peter McGahan
Peter McGahan has a cautionary tale for passive investors and the risk of bubbles to their portfolio.
There are many plus points to investing into passive funds rather than active funds, and of course the opposite can also be said.
My late father loved it when I quoted him “when everyone is running one way, I either stop and go to the side, or run the other way”.
The similarities in investment markets are very real.
A passive fund operates where your pensions/ISAs etc are simply placed into a fund that effectively tracks an index such as the FTSE All-Share, NASDAQ etc. As it rises, your money rises with it, and vice versa. Tracker funds and Exchange Traded Funds (ETF) are the two most popular passive funds.
With these funds you have no control over which specific stocks you are buying – this will become important later.
Their core benefits are the simplicity, the very low charges for investing (you can buy an ETF for around 0.1%) and the speed at which your money can be turned around. For example, many investment portfolios may take overnight to completely sell out. This could mean you are selling at tomorrow’s price, whereas an ETF is priced there and then, and sold instantaneously.
Be careful with choosing an ETF through charges. You are better to use its total cost of ownership (TCO) as a measure as other comparisons don’t take into account certain internal costs like dealing fees, spreads and taxes or swap fees in case of synthetic replication.
Much depends on how your investments are held but over the last three to five years the speed of developments in the investment market has been extraordinary, and if your bank or adviser hasn’t kept up, you will be well behind the curve in terms of performance and charges.
Actively managed funds typically cost more and are supposed to add value by choosing which geographical area, which sector (technology/commodities etc.), and which specific stock.
When our investment team analyse the portfolio of new customers they are very often invested into active managed funds that are highly charged and not active at all, therefore when we screen, the underperformance is a shocking double whammy.
There are a number of outstanding managers who perform well in active management and only with very careful screening tools can we pick them out year after year.
Active management also suits certain sectors better. Consider the commercial property market, which would be part of your portfolio.
A property fund makes its returns by buying property and giving returns based on the capital value rising, and rental income on the property, whereas a tracker for example, cannot do that. Other specialist areas such as technology, healthcare and emerging markets need in depth knowledge of the sector, and often performance can come from small select areas. A passive fund will not be able to focus in on that.
The notable returns at the beginning of the year in FANG’s stocks (Facebook 30%, Netflix 29%, Amazon 28% and Google 21%) stuff the NASDAQ’s 7% and active managers could have easily been doubling down into their exposure to these stocks to maximise returns but equally might have been taking profits over the last few weeks. (1)
Passive funds simply cannot do that and potentially can be exposed to bubbles.
This year marks my 30th year in this role and will mark the millionth time I’ve heard “This time it’s different”.
Bubbles are bubbles and there are often excuses used to pop them. It is most noticeable that the top 5 stocks In the NASDAQ account for 55% of its gains. (2)
As money pours freely into ETF’s and trackers it simply inflates these and other bubbles, as it is indiscriminate purchasing of the stock that an individual manager may not consider to be fairly priced.
This ‘overcrowding’ where the same investors all become exposed to the same key stocks is a key problem and when the warning was sent out over the last month, the inevitable sell off occurred, with passive investors once again exposed to the downturn with nothing they could do about it.
Peter McGahan is the owner of Independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority.
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