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Actively Passive

Published on 29/04/2021

It’s an age long, divisive and passionate debate which splits the investing community: active or passive. There are arguments for both sides with Bernstein analysts calling passive investing “worse than Marxism” and Warren Buffett claiming “active investing as a whole is certain to lead to worse-than-average results”. Well, who to believe?

Active investors aim to outperform the market and believe that investors are irrational: emotions create inefficiencies that can be exploited. They pick their own stocks rather than following an index, and believe the fund manager (or individual investor) has ultimate control.

Conversely passive investors track a specific index like the S&P 500 or the FTSE100 and believe in EMH (efficient-market hypothesis), meaning that by the time information can be processed and acted upon, it’s already ‘in the price’. They replicate the composition of an index and see the index as the ultimate decision maker in their investments. There are a number of passive products in the market as well as indices, such as Exchange Traded Funds (ETFs) and smart beta.

Passive investing began in 1602 when the Dutch East India Company was granted a 21-year monopoly on the Dutch spice trade. They became the first to issue shares on an exchange, rather than in traditional marketplaces. Now we see passive products everywhere.

The influx of retail investors in recent years, and especially during the pandemic is changing the landscape. What once was an exercise of funnelling money into index funds via The Big Three: State Street, Vanguard and Black Rock, now the trend is going it alone (over hiring a portfolio manager to pick stocks for you). Indices investing is seen as a “safer” way to plan for your future - they’ve got a good track record, know what they’re doing and are essentially too big to fail - which flies in the face of YOLO investors, mainly Gen Z investors who are bigger risk takers than previous generations.

Stock ownership varies wildly across the globe, as we might expect the US (and Sweden) lead that list with a little over 50% of the population holding shares or stock.

That number falls across Europe, towards 30%. There has been much research done on why this is and the correlations between stock ownership and income. It is also clearly the case that the owners of stocks have increased their wealth versus those who do not.

According to a recent article in The Atlantic, as of 2016, globally, investors were pulling more than $300 billion annually from actively managed funds and depositing more than $500 billion annually into index funds. Investment in index funds has risen from $2 trillion a decade ago, to a staggering $11 trillion.

If we dig further into stock ownership we find that of the holders of stock, the vast majority do so passively, either through pension contributions, or by actively managing their investments via tracker funds. It is estimated that only 14% of American families hold individual stocks - as of 2019 in the United States, more money is invested in passive funds than in active funds.

But what’s the issue and why are analysts calling it “worse than Marxism”?

Passive investors don’t pay heed to gossip or rumours, there is no fundamental research, they don’t contribute to the flux of the market they just ride the wave and mirror indices of their choosing. It’s been labeled market inertia, an inertia which is making firms less competitive, through “common ownership”, meaning that large scale investment institutions and asset managers control large stakes in multiple competitors in the same industry, be that banks, agriculture, telecoms, airlines. No industry or sector is ruled out.

This common ownership is in turn changing the way corporations behave - if shareholders have interests in all the competitors in an industry, will anyone win out? And if you have piled your money into an index fund, it’s the managers of the fund who take part in shareholder votes, not those whose money is invested. As these money flows into these huge companies which get bigger and bigger a never ending cycle appears, one which will inevitably stop, leaving the retail investors out of pocket.

The passive backlash is coming. Inertia is starting to paralyse the markets - Michael Burry, of The Big Short fame has called it a “bubble”, going on to say “the longer it goes on, the worse the crash will be”. A recent article by Andreessen Horowitz touched upon something we at Upside have believed for a while now: the convergence of active and passive.

Here at Upside we want everyone to be able to actively manage their own investments and financial literacy is at the heart of this. Every investor has different requirements, different financial needs, most believe investing is beyond their reach, paying bills takes everything they have. Actively investing can be daunting at first, but we are developing an education programme as part of the Upside Academy, which alongside our machine learning analytics tool will help users learn investment skills and learn where they are going right, and where they are going wrong.

We believe that anyone can have a great investment idea, they just need the independent data to back them up. There’s a science to investing, and a science to being right.

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