“Markets can remain irrational longer than you can remain solvent.” – John Maynard Keynes
In 2018 the amount of dollars invested passively passed that invested actively for the first time. Does it matter? Yes, it does!
An efficient market is one that gathers and processes all public information about a company and correctly prices the stock. Without investment research, events that happen in the lives of firms go unrecognized. When the news is good this means that gold nuggets lie unrecognized on the pavement. Put another way, without investment research, shares may be mispriced but no one will know and take advantage of the fact that the firm’s shares are actually worth more (or less) than their true worth, called “intrinsic value”. In the case where the market price is way below the intrinsic value of the share, Warren Buffett and his teacher Ben Graham recognize a great investment opportunity. Buying shares of a good business at 50 cents on the dollar is the dream of every value investor!
First, let us point out the rule change that is most unhelpful to passive money managers: The European MIFID2 (Markets in Financial Instruments Directive 2). While this rule applies in Europe it does have an impact in the US and Canada. Under MIFID2, banks are no longer allowed to bundle research with other products. They have to disclose to clients exactly how much research costs in the bundle of products the bank sells to its clients so that the clients can decide whether or not they want “research” as part of their package. The result is that less research is being carried out because, to paraphrase Dr. Johnson “research is worth having but not worth paying for”. No research implies that events, good and bad, in the lives of companies happen but no one is paying any attention. A stock can be severely mispriced and no one will take advantage of the mispricing to rectify it.
The rise of passive asset management is also responsible for enabling mispricing to persist. Since the 1970s, the best advice academics would offer investors has been “invest passively in index funds that track the entire market for a very low fee”. Active asset managers have been shown to underperform their benchmarks and to add insult to injury they charge much more than passive managers do for their shoddy performance. So the answer is obvious: forget about active wealth management, stick to passive, reduce the fee you pay dramatically, track the market average and sleep better at night. In 2018, for the first time the share of passively managed equity funds in the US equalled that of actively managed. In other words in this game, “passive managers one, stock pickers nil”. This win is only possible when passive managers can “free ride” on the research carried out by the active managers who used to be the majority. However, when there is more “passive money” than “active money”, the tables are turned.
This is great news for wealth managers such as Emperor Investments who practice an active-passive investment strategy. We do the research ourselves and invest in great companies at the lowest recent price and stick with them for a long time while collecting their dividends. Emperor’s algorithms will find more and more gold nuggets overlooked by passive managers who stick to the dogma “there are no nuggets of gold to be found in an efficient market”.
Disclosure: Active portfolio management, including market timing, can subject longer term investors to potentially higher fees and can have a negative effect on the long-term performance due to the transaction costs of the short-term trading. In addition, there may be potential tax consequences from these strategies. Active portfolio management and market timing may be unsuitable for some investors depending on their specific investment objectives and financial position. Active portfolio management does not guarantee a profit or protect against a loss in a declining market.