I'm in with the in crowd,  
I go where the in crowd goes,  
I'm in with the in crowd,  
And I know what the in crowd knows …

iangunn Sep 14th, 2017

Around 30% of all assets in the US equity market are in the hands of passive index funds: a six-fold increase in the last 20 years, and a near-doubling in the last 10.

Proposals from the Financial Conduct Authority during the summer are likely to push more UK investors towards passive funds, whilst actively managed funds get squeezed by more regulation and pressure on fees.

Financial deputies get lectured on the efficiency of passive investing, and presented with strong evidence that active managers generally fail to beat the index in mature markets such as the USA and the UK. Even the venerable Warren Buffet (a personal hero of mine too) is quoted as favouring trackers; his two important qualifications are, however, often omitted. First, it is suitable for those who cannot or will not put in the work to pick a small and concentrated portfolio of individual stocks. Second, it assumes the investor is building up capital through regular savings. How can that be so relevant to the recipient of a lump sum damages award to justify a wholly passive approach?

We use passives too: but only with tiny proportions of a portfolio.What do we know that the in crowd does not?

  1. Choosing passive is an active decision.It eliminates the ability of the active investor to steer away from overpriced assets, and just do nothing if that is the least unpleasant option.
  2. Going passive ignores the fundamental component of investment: valuation.It turns investors into speculators.
  3. It presumes some extraordinary assumptions about underlying corporate earnings and profit margins, that do not stand up on rational analysis.
  4. It is a behavioural response (following the crowd and assuming the stellar returns of the recent past will just carry on indefinitely) not an economically rational decision.
  5. It forces the investor to concentrate his or her portfolio in the most expensive assets.

It’s a bit like deciding to spend £100k on an electric car, because it has zero road tax and low usage costs; you are still buying something that will go down in value at an alarming rate, but only seeing the visible costs.

In other words, the price tag is not the annual fund charge, it is what you are actually buying.

Caveat emptor!