Personal Investing
Tom Stevenson 13 Dec 2017 05:41pm

New Year: a good time to get active again?

About a third of all the money invested in the US stock market today is invested in passive funds that simply aim to mimic the performance of a benchmark index like the S&P 500

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Caption: The shift from active to passive is seemingly unstoppable

Ten years ago, just one dollar in five was invested in these tracker funds. In the first half of 2017, $500bn (£374bn) was withdrawn from actively-managed funds and re-invested in passives. This was around twice as much as in the same period last year.

The shift from active to passive is seemingly unstoppable and nothing I say here will change that fact. Investors like the apparent transparency and simplicity of market-tracking funds (you know what you’re getting) and they like the fact that these funds cost less than active funds, which have to pay lots of expensive analysts to dig around for investment opportunities.

Investors have also been persuaded by the argument that most active managers fail to consistently beat the market. If 90% of managers have not outperformed over one, five and 10 years then the odds are clearly stacked against you finding the one manager in 10 who has achieved this. Paying a lower fee for a middling performance might seem reasonable in such an environment.

I don’t intend to rehearse the active versus passive debate here. I’ve done that too many times and the chance of me changing anyone’s mind is slim. As with the Big-Endians and Little-Endians in Jonathan Swift’s satire Gulliver’s Travels, who engaged in pointless arguments about the right way to eat a boiled egg, the side of this argument you sit on is a matter of faith not logic.

I will just mention in passing that buying shares on the basis of their size rather than their investment merits inevitably steers investors towards the most in-favour and over-valued stocks at any point in time (think dot.com bubble for an extreme example of this). Passive investing also necessarily involves buying the worst companies alongside the best. And, as I pointed out last week, it can lead to a much more volatile ride as blissful ignorance of a company’s fundamentals is shattered by the wake-up call of a profits warning.

What I want to focus on today, however, is why now is precisely the wrong moment to be making the move from active to passive. There may be times in the stock-market cycle when the case for simply tracking the market can be made. For a number of reasons, now is not one of them.

The past 12 months have been a vintage year for equity investors. Outside the UK, which has had other things on its mind, stock markets have delivered fantastic returns. Buoyed by reasonable earnings growth and the prospect of more to come as the world enjoys a synchronised recovery, investors have been happy to bring forward next year’s returns into this year. We have enjoyed double helpings of capital gains in 2017 and I expect returns in 2018 to be much harder earned.

The bull market since 2009 has been long and strong. In duration, it has only been exceeded by the 1990s in the post-war period. The quadrupling in the S&P 500 puts the current rally on a par with the golden age between the fall of the Wall and the attack on the twin towers.

The drivers of the nine-year bull market are, however, largely played out and this year’s technology rally and, in particular, the madness of bitcoin suggest that sentiment has taken over from fundamentals. The lack of euphoria in the mainstream stock market provides some reassurance but we are certainly in the final inning of this game.

That is the bad news. Offsetting this is the fact that there is little reason to expect a bear market in 2018. To believe that will happen, you have to think we are on the brink of a recession or that inflation is poised to return with a vengeance, pushing interest rates up much faster than either investors or the Fed currently forecast. Neither of these looks particularly likely.

But putting money to work in the stock market makes sense only if you think the potential reward outweighs the possible risks. With the S&P 500 at more than 2,600 it is fast closing in on the 2,700 that has looked like a sensible target for some time. So the market as a whole may go up a little but, having risen four-fold in 10 years, I’d suggest it stands a reasonable chance of retreating by rather more. The risk and reward is, therefore, asymmetrical right now.

If volatility remains low then another few percentage points of capital plus dividend income might look alright in a context where cash and bonds offer such paltry returns. If, as I expect, volatility returns next year as investors respond to central banks finally delivering on their promised tightening of policy, then the rewards may look a bit more marginal.

But this is at the aggregate market level. It is a good reason to be suspicious of the siren call of low-cost market trackers that guarantee to deliver you market returns minus fees. It is an equally good reason to roll up your sleeves and go to the effort of identifying that minority of fund managers who have the ability to deliver consistent returns.

The 30 year collapse in real interest rates has provided a tailwind for equities. The rising tide has taken away the need to pick winners and avoid losers. Just turning up has been enough. This won’t be the case next year and probably for many years to come. In more ways than one, the New Year will be a good time to get active again.

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