- Passively managed funds are extremely dangerous as their positive performance is self-reinforcing due to the huge positive net inflows.
- But don’t jump to actively managed funds as, on aggregate, they will always underperform the market in the long term because they are the market.
- The only solution is to invest like a business owner. You can do this by investing yourself or by finding an active manager who has the same principles.
A recent Wall Street Journal article described how BlackRock (NYSE: BLK) is switching to robots from using humans to improve its stock picking for its actively managed funds. BLK’s reasoning is that its stock picking unit lagged in performance and has had many withdrawals that cut assets under management to $275 billion from $317 billion in the last three years despite the S&P 500 surging 27% in the same period. The hope is that robots will perform better at lower cost.
Using robots is yet another indication that individual stock picking skills are currently out of favor. The rise of passive funds has completely overshadowed active funds which continue to see huge outflows.
Passive vs. active fund flows in 2015 and 2016.
In aggregate, actively managed funds have had an extremely bad time in this bull market.
Cumulative inflows into passive and active funds since 2008.
It’s easy to understand the attractiveness of passive funds as the S&P 500 has gone straight up in the last eight years rewarding investors with returns of 219% since March 2009 with extremely low volatility.
When an asset class performs so well for a long period of time, many convince themselves that the specific investment is the smartest investment as the only indication of risk is, in this case, more than eight years behind. However, mindlessly investing into something just because it has been going up is a dangerous strategy.
Something that’s very indicative of how investors breathe is this five-minute CNBC video where participants discuss the market. Valuations are never mentioned and, according to the participants in the video, the variables that should or could impact the market are political, technical, tax, or legislative in nature.
Unfortunately, mindless buying will lead to mindless selling when mom and pop investors realize they have been buying hype and start to sell in a panic. As no one will be able to control the outflows, the downside is huge.
If passively managed funds are so risky, should you switch to actively managed funds? You might be surprised by my answer, but actively managed funds will never beat the market on aggregate because they are the market. When you add fees into the equation, active funds are bound to underperform.
Now, if passive investing is extremely dangerous and mindless while active managers are bound to underperform, what is the best course of action? The answer is: be a business owner, don’t own stocks. Look at the businesses represented by stocks and then buy them at a fair price.
Business owners have a different perspective on their business than people have on stocks. I would guess that most of you know an owner of a farm, family restaurant, or other type of business who is only interested in the cash flows their business provide them every year, and not at all interested in the price of what they own. But I bet they were interested in the price of their business when they bought it or invested in it, and will be interested in the price of it if they ever wish to sell it. In the meantime, their only focus is on how to increase cash flows.
Stock certificates should be treated the same: as parts of a business that are supposed to deliver cash flows in the future. The present value of the future cash flows is the business’s intrinsic value. Those cash flows can be paid out as dividends or reinvested to increase the business’s book value.
Stocks are a way for anyone to be a business owner as you don’t need vast amounts of capital to own part of a business. Additionally, stocks offer liquidity and diversification possibilities. However, the same liquidity and diversification leads investors to trade stocks and look at them as pieces of paper whose value changes every day.
Whenever I have treated my investments as businesses, my returns have been fantastic. When I have tried to buy something just because the price was supposed to go up at some point in the future, my returns haven’t been that great mostly because I took profits too early.
At the moment, I know that a bear market triggered by a U.S. recession or some other shock will significantly lower the value of my portfolio. What I don’t know is when this will happen, though I know that if I’m not invested my opportunity costs are huge. The businesses that I own, their nature, fundamentals, and earnings, are what gives me peace of mind as all of them are extremely undervalued from a longer term perspective. Therefore, whatever happens in the market, I know that in 5 or 10 years from now my returns will be closely correlated to the earnings produced by the businesses I own. I hope I won’t have to wait that long because I plan on selling my holdings as soon as they become overvalued, but if they don’t reach that point in the next 10 years, I’m happy to hold on to them.
Active fund managers don’t have the luxury of waiting a few years for their idea to develop. They are limited by the pressure of short term performance which forces them to take action that doesn’t provide the best long term value, but rather the best possible short term value in order to attract more funds. This lowers their long-term performance as it isn’t investing, but betting. We’ll only know which is the best investment strategy when a full market cycle has passed, but the majority of investors prefer to look at short term performance. This leads to high risks that disregard fundamentals, and panic selling which leads to sharp stock market drops.
My point is that every investor should look at what he or she owns. If your portfolio consists of several mutual funds, blue chip stocks, and a diversified portfolio of bonds, please make sure that you understand the relationship between the business represented by those securities and their current stock price.
Let me give you an example of businesses that clearly describe what I mean.The best example to use for comparing an owner’s business perspective and the market’s perspective is Berkshire Hathaway (NYSE: BRK.A, BRK.B). BRK directly owns many household names and has stakes in large U.S. companies like The Coca-Cola Company (NYSE: KO), American Express (NYSE: AXP), and, recently, Apple (NASDAQ: AAPL).
Now, if you’re a business owner, what you’re interested in is that earnings grow but you also know that there will be periods when earnings won’t grow because of economic circumstances or certain losses from parts of the business. If you own a well-diversified portfolio like BRK, you don’t have to worry about the business as the probability of it going bust is minimal.
The market has a completely different perspective on BRK. At certain moments in time, it’s willing to pay huge amounts for owning a part of the company but at other moments, stock prices get so cheap that it looks like nobody wants a piece of the above businesses. In the last 20 years, BRK’s stock has fallen more than 40% on two occasions and has had nine declines larger than 10%.
BRK had two 40% declines and nine 10% declines in the last 20 years.
Do you see a pattern here? The problem is that the sharp declines can’t be predicted while selling after a 10% drop would cost you a lot like it did for those who sold at the beginning of 2016 thinking that a new crash was coming.
Going back to stock picking, if you own a great business like BRK and bought at a great price, you can be sure that you will reach satisfying returns in the long term. If you own a bad business or an overpriced business that doesn’t create long term value, you’ll lose a lot in the short term but also in the long term. Therefore, it’s essential to pick great businesses at good prices as this is the only guarantee of good returns.
The passive investing mania will pass with the next crash and the companies that were bought just because they were in an index will never reach their current values again.