Why Passive Investors Get Hammered

hammer_PNG3886-1024x787This is the title of a recent post by Mike Posey of Theta Research.   The chorus of passive investing continues to grow as the stock market moves to all time highs.  The idea is that you should just buy and hold a bunch of different asset classes in the market and thus will be “diversified” and should do fine over time.  We believe this is not a prudent strategy for investment and wrote recently HERE, HERE, and HERE  how passive investing is basically having an offense with no defense and can expose you to more risk.

He addresses the problem with traditional asset allocation methods for passive strategies:
“Unfortunately, limited tool selection can affect the quality of your work. For example, risk management in a passive asset allocation portfolio is generally expected to come from low correlations among the asset classes chosen. The only problem is that actual experience during bear markets has shown that these low correlations can actually increase during down market cycles (remember 2008?). The result is that asset allocation’s tool to manage risk can disappear just when you need it most.”

He then shoots another hole through the passive strategy dogma that over time your account will recover any loss:
“Asset allocation believers offer the standard line that the market will eventually regain its value, and for proof, they point to the fact that every drawdown has eventually been erased by the market. Well, every one except the Nasdaq Composite’ 75%+ drawdown which has still not been erased even after more than 14 years of market action. Buy-and-hold aficionados don’t talk much about that statistic.”

So what is the impact on your portfolio of large drawdowns like we have experienced twice  in the past 15 years?
“Unfortunately, the price paid by many investors for following a passive investment strategy is often the most valuable commodity of all – time. While the financial press continues to gloat about hitting new record highs, it conveniently ignores the fact that, since the year 2000, the stock market has spent much of the time either losing money or regaining lost ground. And when we talk about investors meeting their long-term financial goals, time is money.  And it gets even worse: not only do losses require you to use valuable time to recoup portfolio losses after a drawdown, you have to earn a higher return to get there. As we all know, a 40% loss requires a 66% return just to get back to breakeven. That’s a double whammy if I ever saw one.”

We believe here at Parallel that active management truly adds value by providing a defense to help avoid the big drops in the markets.  Mike sums it up best here:
“The moral to this story is that investment professionals need to diversify their clients among different investment strategies, both passive and active – and not just a selection of various equity and bond holdings. Doing so could help portfolios weather the next storm (which some say is overdue) rather than getting hammered.”

Click HERE to read the entire article.

Source: Brian Boughner, CFA, CMT