Passive investing, usually entailing the purchase of low-cost index trackers and Exchange Traded Funds, has seen a massive boom in popularity since the financial crash. Numerous financial wizards, including Warren Buffet and John Bogle, have advocated for passive investing, arguing that it’s far more suitable for the majority of investors than active share trading.
The arguments in favour of this are numerous; active trading usually incurs higher fees than passive, most active investors fail to outperform broader indexes over the long term (so why bother trying?), and many people fail to look objectively at their investing performance over the long term, paying consultants who recommend high-fee managers who then fail to generate significant enough returns to justify their fees.
So why am I an active investor?
My answer is a simple one. I educate myself. This is the single step that most people fail to take when controlling their finances, and consequently incur poorer performance than if they’d simply bought an index fund. I spend between 5-10 hours a week reviewing my investments and educating myself about investing.
There’s no such thing as easy money, and I know that. I prioritise my financial education over other things and ensure that not only am I learning, but actively applying the principles and lessons I’m reading about. I test out theories with a small pot of cash and figure out what works before I pile in bigger sums.
By contrast, passive investors are leaving their financial future to other people; their bank manager, investment advisor, pension advisor, financial planner…luck…
I question how many people that have bought ETFs or index trackers and really understand what it is that they’ve bought, or what makes the value of their investment fluctuate. The financial crisis of 2007/8 was caused by a number of things; one of which was hard to understand mortgage products. I wonder whether we’re saving up another problem by piling into passive investment products without really understanding them.
As an investor, I prefer to take an active role in companies, using my money to fund issues I care about such as renewable energy, or supporting small businesses seeking to grow and create jobs for others. If I bought an index tracker, my money would instead be blindly split across hundreds of established companies. I wouldn’t be choosing how my money acted, I’d just be following a statistical model – to hell with any ethical considerations!
I totally understand that not everyone is necessarily interested in finance and investing in the same way that I am, and I totally understand that not everyone is of equal intelligence (you’re not likely to find me studying statistical analysis at Harvard, for example), but one thing I will always believe is that people should educate themselves as best they can about their finances and what they are doing with their money.
The narrative around passive investing; that it’s low-cost, statistically likely to grow at an average of 4% a year over the long-term, and low maintenance sounds to me like the narrative around Mortgage-Backed Securities in the run-up to the financial crisis. Subprime mortgages were bundled up in tranches and sold as safe investments because of the diversification in risk profiles. It sounded sensible at the time, and people piled into them, never looking at what they were really buying; that ended well, didn’t it?
Investors who have bought a tracker fund in 2008 have enjoyed fantastic with both the FTSE and S&P having reached record highs. But as stock markets continue to climb, I wonder if people are prepared for the inevitable market correction. Banks have been pumping hundreds of millions of pounds, dollars and euros into western economies via quantitative easing, interest rates are at pretty much 0% across Europe and America and one day that is going to change.
Millions of people have piled into passive investments, squirrelling away money each month, but ignoring what they’re buying, and resting on their laurels as the rising tide of general markets grows their investments. That’s fine until the markets turn – then, people might wake up to what they’re investing in; how highly leveraged are the companies that make up the indexes? How strong is their cash flow? How loyal is their customer base? How diversified are their revenue streams? Passive investors have got no idea how to answer those kinds of questions, and when the music stops (which it always does – every ten years, on average), there are going to be some serious shocks.
Compare this to my active investment strategy, where I understand the balance sheets of my investments, understand their markets and leverage, understand their strategies, and in some cases know the individual management teams I’m investing with. When the next correction comes round, I won’t be panicking, I’ll be topping up my portfolio at a discount, focussing on companies with strong cashflows and dividend yields, low leverage, and a history of significant reinvestment.