The true cost of passive investing

It seems as if passive investing — index and exchange-traded funds — has won the performance battle in today’s financial markets. Trillions of investment dollars now rest in massive pools, while investors question why they pay active managers anything for investment advice.

But all good trends can be stretched too far. And a growing number of investors say that the indexing craze has created a bubble that’s inflating the value of stocks across the market.

Charles Brandes, founder of Brandes Investment Partners, is one of the voices sounding the alarm. With bubbles, price dislodges from intrinsic value, Mr. Brandes said, and bubbles are difficult to catch because they can only be realized in retrospect, no matter how frequently the word is used on television.

Indeed, investment advisory firm Ned Davis Research made the following prediction in March 2017: “We are in the last phases of a passive index bubble” presenting “a great opportunity” for active managers to outperform passive funds.

The firm sees the signs of excess everywhere. This time the distortion is different because of the breadth of the buying wave. The average stock in the Standard & Poor’s index rose to 2.5 times sales in 2018, compared with 1.6 times sales in 2000, at the height of the dotcom bubble, which was confined to growth stocks.

Investors need an active money manager for one simple reason: to protect them from themselves. As bad as active managers are at beating the indexes, individual investors are much worse.

(More: Active vs. passive: The case for both)

Dalbar’s Quantitative Analysis of Investor Behavior study shows investors rarely spend more than four years in any fund or strategy. This devastates their returns over time because investors sell when they should buy and buy when they should sell. Over the last 10 years, the average equity fund earned 11.02% a year, versus the individual investor’s 8.31% a year. The 32% difference more than makes up for any “excess” management fees charged by active managers.

The gap is widening as investors become ever more sensitive to increasingly sharp market swings. Over the 12 months ended Sept. 30, the average equity fund made 15.19% while the average equity fund investor made only 11% — a 41% difference.

Increasingly, the decision on the mix and movement of money between index funds rests with individual investors — the people who are least adept at managing money yet somehow convinced they should do it themselves.

In truth, they have become ever more vulnerable because of the impact of financial broadcast journalism, which is voraciously hungry for ratings and not above pressing the panic button time and again.

Look at what happened when the Ebola scare stories pressed airline stocks like American Airlines down to unprecedented lows, only to have the shares bounce back soon after the panic abated. How many times since the financial crisis have we allegedly been going into a recession or worse?

“Before we were having a bumpy road. Now we’re witnessing whiplash,” said Dalbar CEO Lou Harvey.

Investors buy an active manager or an adviser, who chooses to be somewhat different than the markets they are trying to outperform,and they count on the manager to exercise skills and experience accumulated over years of successful investing. They count on them to do everything they can to protect long-range returns. To an active manager heavily invested in his own venture, losses are not academic.

Investing with an active manager, the investor is admitting that their financial ship needs a pilot and they are hiring one with the best style that suits their needs. They stop chasing performance, and let their pilots do their job over at least a five-year span or longer. They focus upon long-term goals, not short-term gyrations and noise.

“What my studies call for is a trusted third party,” Mr. Harvey said. “The individual investor is not going to be up on the latest information. The manufacturers of financial products want to gather assets and sell products. Their goals are opposite that of the investor.”

Take the time to understand the high costs of changing your mind. The financial future investors are saving for should be their main objective, not reacting to the crisis of the moment.

(More: Vanguard defends the value of active bond funds)

Scott Schermerhorn is chief investment officer for Granite Investment Advisors, a fee-based service following the value discipline.