In 2019, the amount of money invested in passive funds in the United States surpassed that of active funds for the first time.1 Over the last decade, passive funds have increased assets under management to $11 trillion, from $2 trillion.2 Given the title of this piece, are we saying that all that money is in the wrong place?
Our issue isn’t necessarily with passive funds – we deploy some ETFs in our investment management strategies. Our issue is with the sea-change in portfolio management that the availability of low-cost index-tracking funds has brought about. It’s the prevailing idea that you can create an effective, all-weather asset management strategy by buying a bunch of different funds that represent different asset classes.
The Commodity Trend
Our foundational insight is to turn on its head the belief that asset management has become commoditized. We believe that for much of the asset management industry, investors are the commodity. Most advisors use a one-size-fits-all pie chart strategy. They do a little tweak for your age and how far you are from retirement, and their tools spit out a portfolio recommendation with a bunch of different funds in it. Their theory is that these
magical beans funds are going to work together to lower risk and maximize return.
They believe this because they are using data mostly since the early 1980’s to support their recommendation. The problem, as we discussed recently in our “Inflation Waves” report, is that almost every asset class has risen since then.
So they are looking at data that does not include some major market cycles. Specifically the one that we believe we are entering into now…one of rising interest rates and rising inflation.
The words “broadly diversified” have become a mantra, used by large and small firms alike, recommending that investors should be in all asset classes at all times. And meanwhile, broad market indexes like the S&P 500 are only getting more concentrated. It’s hovering around 27% in the IT sector, as defined by GICSs. But if we include companies like Google, Amazon and Facebook, tech exposure is close to half of the index. So, what is that doing to asset allocations?
The notion that diversification is an investment strategy that can replace a disciplined, rules-based investment process is where we draw our line in the sand.
Market Cycles are King
An asset allocation based on age is going to bump up against the realities of the world. Economies and businesses have cycles. Add in the natural human behaviors of fear and greed and you have the market cycle.
And the market cycle doesn’t care how old you are.
If you are lowering your risk during a period when market cycle signals indicate risk is low already and the potential for return is high, you are leaving money on the table. And vice versa.
Diversification Doesn’t Manage Risk
We aren’t suggesting that risk management isn’t necessary…quite the contrary. We believe the management part is important. Volatile markets require a system to manage risk. Being 50 years old or five years away from retirement isn’t a system, it’s a statistic.
Unfortunately, diversification fails exactly when you need it to work. Data shows that asset correlations rise when volatility rises. This means that when markets undergo stress, most assets fall at the same time.
The reported benefits of diversification (having assets that perform differently during different periods) simply isn’t true. In fact, the opposite what happens in the real world.
Rules Are Good
So if passive investing is not the way to go, and broad diversification isn’t all that great, what can you do?
First, we must recognize that investing is inherently emotional. We spend a lot of time with our clients to ensure that their emotions will not impinge on their investment plans. The best thing a client can say to us is that they don’t worry about the money we manage for them, and we strive for that with every client.
We do the same thing with the money we invest. We are tactical investors that follow a rules-based process in each of our portfolios. Simply put, we look at the underlying trends and momentum in the markets to determine good and bad environments. And then we make adjustments to our client portfolios, daily, weekly, monthly – whenever we identify either an opportunity to exploit or a risk to avoid.
That might mean we are broadly exposed to different asset classes; it might mean we are relatively concentrated in our exposures. We just don’t believe that identifying asset classes and then keeping exposure to them through every environment is a successful strategy.
The goal of our process is to participate in up markets and mitigate risk in down markets. Said a different way, our goal is to do more of what’s working and less of what’s not.
Passive management cannot do that. It can only allow you to participate in up markets while also participating fully in every down market.
Ultimately, a passive investment strategy works in up markets. But that is only part of the market cycle. When the down market comes, your (or your advisor’s) emotions take control. That’s when mistakes happen.
The answer is simply to develop, test and implement a rules-based process.
If you can prove a process works in different environments, and stick to that process, then you can have confidence that your system will work during all parts of the market cycle.
That is active management. And that is what we believe works.
- Lowery, Annie. Could Index Funds Be ‘Worse Than Marxism’? The Atlantic. April 5, 2021.