There is a concept of "active investment". In this case, we are trying to choose the composition of our portfolio based on some factors – fundamental indicators, mathematics, news.
What is passive investing?
Passive investing is when an investor deliberately refuses any choice. It collects a portfolio that is structured exactly like the broad market index. That is, it turns out a kind of string bag into which all the products from your nearest store were crammed (this is figurative).
The investor chooses only geography and the ratio between asset classes: stocks, bonds, goods, real estate.
That is, the recommendation for the portfolio sounds like this:
Buy the S & P500 Broad Market Index. Buy a bond index. And do not twitch.
Now comes the fun part. In 2008, a chimpanzee named Lukerya showed itself in the stock market. The monkey randomly collected a portfolio of securities. After 10 years, the results of this experiment were summed up. It turned out that Lukerya outplayed many fund managers.
What is it doing? All those uncles in pretty jackets and shirts with gold cufflinks don't know a damn thing? Yeah, that's right. 🙂 Why do we give them a percentage for management? Because they are idiots.
Let's explain the nature of this phenomenon.
Let us first turn to the theory of Harry Markowitz. Harry is a Nobel laureate and inventor of modern portfolio investment theory.
I will describe the theory briefly:
- There is a direct relationship between risk and return.
- Risk is more important than profitability.
- Risk is measured using the standard deviation of expected returns (in other words, how much you can be shaken in a particular asset class).
- The risk can be mitigated by building an “optimal” portfolio.
- Diversification does not rule in one asset class. Example with stocks. If the market falls, then almost all stocks go down.
- Diversification rules across different asset classes. Is stocks bad? But gold is good. Is Bonds Bad? But stocks and real estate are good.
- Diversification does not minimize risk. She only shortens it.
- The investor must refuse to consciously choose securities.
- There is no point in catching a market entry point. Don't look for the bottom.
Let's now turn to the world's best investor, Warren Buffett. Let me remind you that Buffett is an active investor. And here's what he says in an interview with CNBC:
Your first investment is best in a low-cost index fund like the S&P 500. This is a great all-time investment approach.
Amazing! Why does he even think so?
At the heart of a passive investment strategy are two critical factors:
- Positive mathematical expectation at the expense of companies' profits. We know for sure that in the current world order there will always be companies that make a profit. This profit will definitely go to shareholders in the form of dividends.
- Positive mathematical expectation due to asset price growth. Markets are constantly growing. Yes, there are very, very long falls. But on average, throughout our entire investment period, we more often see an increase than a fall. There are a lot of reasons, let's leave them to economists.
All passive investors profit from this. They know in advance that mathematics is on their side and simply take advantage of this advantage.
There are more and more passive investors in the world. In August 2019, Morning Star for the first time in the history of the US stock market recorded an excess of amounts invested in passive funds over active funds.
Passive investing principles
- We no longer try to choose stocks.
- We use 2-4 asset classes. Stocks, bonds, goods, real estate.
- We estimate the best portfolio for ourselves. Example: 50% in stocks, 50% in bonds. Or 75% in stocks and 25% in bonds.
- We rebalance once a year. Are stocks up? We sell them, and with the proceeds we buy shares. Have stocks dropped? We uncover the "safety cushion" of bonds and buy additional shares. That is, we align the percentage to the initially set parameters.
- We are not trying to search for an entry point. We enter the market here and now.
- We do not catch the bottom and crises. It's useless.
- We forever forget about news, geopolitics, expert opinion, volatility, etc.
- We are not trying to guess the future. We don't care where the market goes.
- We are not trying to overtake the index.
- Passive investment instruments. ETF
Let's first highlight two instruments – mutual funds and ETFs.
What is ETF – Exchange Traded Fund (ETF)
What is a mutual fund – a mutual investment fund.
They are not the same thing. There are significant differences:
- Both are collective investments. Investors' money is combined in a string bag and invested in certain types of assets – stocks, bonds, etc.
- The mutual fund is actively managed. Some manager somehow makes decisions about the proportions of assets, the time of purchase, etc.
- The mutual fund is sold at the office of the management company. And ETF is on the exchange.
- The ETF value is maintained in line with the value of the underlying assets.
- ETFs have a much lower commission.
- ETFs are more liquid.
- ETF is more reliable. Because it is more tightly controlled.
- You don't waste time. Don't waste at all.
- Index ETFs perform better than many active funds. This is a fact, and there is a lot of evidence on the web.
- Passive managers ask for a minimum commission. At a distance of 30+ years, this will have a very serious impact on the size of your capital.
- Passive funds do not depend on the skill of the manager.
- It's psychologically easier to sit in an ETF than in a separate stock. You are not attached to the instrument. ETFs are just an impersonal and soulless shell.
- The likelihood of going broke in a passive strategy tends to zero. It is much lower than in other strategies.
- ETFs provide an opportunity to build a global portfolio with minimal effort. We are not dependent on problems in a particular country.
- ETFs minimize the risks of individual issuers. We do not care about the problems of one single company or state.
Cons and risks
The main ETF risk is liquidity risk. When selling ETFs, there is an intermediary that gives you liquidity. It is unclear whether such an intermediary will have enough strength in the event of a mass exodus of passive investors from the market.
- Today, many US housewives and retirees are sitting in index ETFs. This is the crowd. The crowd is easy to manipulate. For example, through the media.
- Over the past 10 years, we have seen an unprecedented bull market in the US stock market. This greatly facilitated the transition of active investors to passive ones. I would very much like to see how these people will behave during the period of a prolonged fall. For about 20 years, I don’t think that many are able to withstand first a sharp drop in their assets, and then a long straight line without any growth and with microscopic dividends.
- You do not own a stock or bond, but a receipt that you have a certain set of securities. That is, you take on the risk of the issuer of the stock and the risk of the issuer of the ETF. Yes, ETF issuers are very, very reliable. But the risk is still double.
- Passive investors only pretend that they are passive. In fact, they make decisions too. You need to choose a fund. You need to choose a country. You need to choose the proportion of assets. There is a non-zero risk of making a mistake in this choice.
- ETFs are just a portfolio. Someone else's portfolio, collected by someone according to a certain principle. Not the fact that this principle will be better than yours.
- Speculators are making a big contribution to current pricing and liquidity. The market could not exist without them. But passive investors are dormant. If suddenly this volcano wakes up, it can devalue many assets included in the indices. This is especially true for the shares of small companies.
To complete the picture, let's take another look at the history:
- Bankruptcy of the management company. So far, it has never been.
- Liquidation of a single ETF. It happens all the time. The assets are sold, the money is returned to the account.
- Broker bankruptcy. The money is transferred to another broker.
- Country risks (sanctions, etc.). Most likely, they will forcibly sell assets and ask you to withdraw funds from the account.
Interesting features of ETF
All American ETFs pay dividends, which is a big plus. Domestic ETFs do not pay dividends, all funds received are reinvested automatically.
Taxes. If you are serviced by Interactive Brokers, you will need to report to the IRS yourself. We'll have to take into account the growth of the body and the growth of the exchange rate difference.
When investing in US ETFs, you will not be eligible for a tax deduction.
If you buy “our” ETFs through an RF broker (for example, Finam / Tinkov / BCS), then you have the opportunity to keep them on the IIS and receive deductions.
If you buy ETF through a broker in the Russian Federation (you need the KVAL status), then there is often a confusion with taxes. For example, in Finam I was assured that they would take care of all the troubles.
You should check this information regularly with your broker.
There are a huge number of ETF types: by asset type (stocks, bonds, commodities, real estate), capitalization, industry, country, with or without leverage, inverse, by the type of strategy (dividend, value, growth funds, wide moat, etc.) ), government or corporate securities, by maturity (for bonds).