Passive investment – an unwitting oxymoron

The purpose of a good debate is to open ourselves up to discussions out of our comfort zone. In this regard, I hope this short missive does this inasmuch as hopefully challenging a belief that passive investing is an option (all investments are active, by definition), and that while managing to a fee budget is important, it is not the key driver in determining NET and uncorrelated returns.

Regardless, while I do accept the aforementioned points, my own take is respectfully slightly different inasmuch as my preferring to differentiate the word "investing" from "trading". As any investor, we own the assets and its intrinsic worth is a function of earning/cashflow/divis/book value, not a function of price. Valuations then move up/down based on what other investors are willing to pay for such an implied return. So to say that if the world were 100% passive, would that necessarily change the fact that we own its intrinsic returns, and that companies income statements can and will vary?

I know, you're talking to a die hard. But then again, never was one who believed we live in a physicist's "vacuum".

Happy hunting my fellow investors.

Hi Gavin, this is a good discussion to be having.

I can't agree with your belief that the market would deliver a nil return if there were only passive investors.

First, the companies would make earnings and pay dividends. So there would be that simple income return at best.

Second, assuming that there is a flow of passive investments coming and leaving the stock market, there would be transacting. As earnings grow - or fall if a company struggles - then the price at which those passive flows would transact would have to be based on some sort of valuation process. Let's be positive and expect that for the overall market there will be growth, then there will also be increasing share prices to reflect the fact that the NPV of the future income stream will keep on rising.

Third, just as with direct property holdings in a portfolio, investors could always also choose to have their holdings of shares in a totally passive market revalued. Again, as long as earnings grow, the share price will get revalued upwards.

Of course, if in theory we only had this sort of passive investing, the market would operate differently - eg more like the property market as per my point 3. It might make the stock market more attractive to a lot more investors if it took the speculative run ups and downs in prices out of the equation! The current operation of stock markets is what it is because there are active managers needing that level of liquidity to trade, but if there were a different set of investors, then stocks could be bought and sold in other ways than at the moment.

That's not going to happen of course and nor do I advocate for a change. My point is simply that many different assets operate in different types of markets. It's not the mode of that market's operation that results in returns, but the earnings the assets generate.

As a financial adviser of over 20 years experience, I recommend a mix of passive and active strategies and investments to the majority of my clients, and I also hold a mix in my SMSF, so I'm not seeking to serve my own interests in my comments.

If you think logically about what I said, my comments were aimed at the fact that if everybody invested into "the" market by passive means, then the market would produce a nil return because no individual investor could bid up or down a particular stock included in that market.

As long as there are active investors in the market then passive investors will benefit (assuming the market goes up!), and it is in the interests of proponents of passive investing that there is a healthy dose of active investor participation.

"Passive investing only generates a return thanks to the activities of active investors."

So? Active investors can only trade in the stocks they want to buy or sell if other investors, whether active or passive, are also trading. You could push this line further and say that growth investors need value investors to sell to them the companies they want to buy.

The point is, we are ALL dependent upon the existence of a market in order to participate in the market.

That is in no way an argument for or against any particular investment approach - active, passive or otherwise.

And Jerome's argument confuses me, too. Usually proponents of active management argue that they can exploit market inefficiencies, but now we're being told that passive managers need active managers to create an efficient market.

Will the spin of people in this industry seeking to serve their own interests never end?!

(I use a mix of active and passive in my portfolio, by the way. But I'm not trying to sell my management services to anyone else and that is not advice to anyone that they should do the same thing. My only advice is to be very careful about the arguments that proponents of anything put forward - they have to stack up analytically and factually, not just sound good.)

To follow on from Jerome's comment, another fact is that a strategy of passive investing only generates a return thanks to the activities of active investors. If for example 100% of investors looking to invest into the S&P/ASX 100 (using Rob's example from his article) wanted to do so via an index fund or other passive approach, then no single stock would or could outperform or underperform any of the other 99 stocks.

This is an argument I've made previously and it's an issue that is ignored by proponents of passive investing.

Here is another oxymoron. Supposedly passive investing not only relies upon an active decision, but on active management providing price discovery and market efficiency. Given market action of late and frantic price movements one has to wonder whether active management is providing the market efficiency needed or whether central bankers and market players have turned certain markets in to something resembling a Chinese equity market casino!

The way that the word 'momentum' is used makes the suggestion that all short term movement is due to momentum. Of course it could be due to changing fundamentals as well.