Why Passive Investing Is More Wall Street Marketing Pitch Than Reality

Nessie. The Yeti. Bigfoot (Sasquatch, if you prefer). The connection between autism and vaccination. The New York Knicks' chances of winning the NBA title next season. The common thread between all these: They're mythical -- if not farcical. Fake news, in today's parlance.

To that list, I'll add one more: the supposed rise of "passive" investing. This, too, is mostly a myth and, given recent developments in index creation, it's well on its way to becoming a farce.

First, a definition: Passive investing is based on the belief investors and managers are unlikely to reliably beat markets over time. So, rather than try, just mirror the index, minimize costs and never touch a thing. By doing so, passivists claim you'll outperform most active investors.

Which is a fair enough point. Most active managers' long-term history (if they even have one) doesn't compare favorably to broad market indexes -- a fact the media notes ad nauseum in its celebration of passive's "rise." Yet the reality is passive investing would only improve returns if it were actually adhered to. The mere existence of many index funds doesn't mean folks are actually deploying them in a passive manner.

Most often, investors buying index funds first make active decisions about asset allocation -- the mix of stocks, bonds, cash and other securities they invest in. Then, in my experience, most index investors blend together a slew of different index funds, resulting in a portfolio that doesn't mirror any identifiable stock index.

They are making active decisions at the sector, size, style and country level. And on top of that, most investors -- passive or active -- struggle to stay disciplined in times of greed, fear or even boredom. There is no evidence I've seen suggesting investors are really great at actively determining which categories will be in favor. There is lots of evidence suggesting investors without counsel often trade emotionally, negatively impacting returns.

But even then, for all the talk of passive's rise -- which has been documented by virtually every investing publication in the world this year -- the evidence is flimsy.

For example, while I buy the notion that 2017 is on course to post record inflows into exchange-traded funds (ETFs), positioning this as a sign of "passive popularity" is beyond bizarre. Yes, they track indexes, but do folks not see the word "traded" in the name? If the primary attraction of a product is the ability to trade it often, it's hard to see how this is a victory for passive. Just last year, five of the top 20 most heavily traded securities in America were ETFs.

This is doubly true considering the nature of the index products gobbling up so many assets these days. Many track custom indexes built to emphasize a feature (or several features) the index designer thinks will generate superior performance. Smart-beta index funds -- those aiming to deliver the calorie-free cake of lower volatility and stock market-beating returns -- abound.

Believe it or not, one provider just launched the Quincy Jones Index to underpin the soon-to-be-launched Quincy Jones ETF targeting media and music-industry related stocks. For those who aren't hip, Quincy isn't a quant analyst over at Goldman. He's the Grammy award-winning record producer responsible for Michael Jackson's Thriller, among others.

The goal of these indexes undercuts their claim to passivity. Nothing claiming to deliver "superior" or better "risk-adjusted" returns than a typical market-cap weighted index can be seen as passive. Think of what they're doing: They are creating lists of stocks based on criteria they like and think will do well. Then they buy stocks on the list. That's active management!

Indexing would include stocks the creator has no opinion of whatsoever. A true passivist shouldn't have any view of where markets are headed or what should do well, because the very philosophy hinges on humans' inability to foresee that. Yet even some of passive investing's founding fathers are getting into the mix, revealing the reality: Passive in practice is largely a marketing pitch.

To be clear, I'm not hugely critical of index funds -- they can be effectively deployed in a top-down active manner -- or the notion of passive investing generally. If it were possible to do it, that would be great. But the fact is passive investing is less a "revolution" or "threat" to active investing and more an ivory-tower theory that doesn't translate to real life. Or, perhaps, it was an ivory-tower theory. Now it's a Madison Avenue one.

The notion of "going passive" has always been much more myth than reality. The difficulty now is Wall Street figured that out -- and is pumping out products pushed with a passive pitch. If you believe that means active management is dead, I have some New York Knicks 2018 Championship gear I'll sell you cheap!

Michael Hanson is senior vice president of research at Fisher Investments, an independent, fee-only investment adviser serving investors globally. To learn more about Fisher Investments, please visit www.fisherinvestments.com.

The content contained in this article represents only the opinions and viewpoints of the author. It should not be regarded as personalized financial advice and no assurances are made the firm will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

More from Investing

Former Disney COO Emerges as Leading Candidate For CBS Job

Former Disney COO Emerges as Leading Candidate For CBS Job

Amazon and Oracle's Beef Is Carrying Over to the Courtroom in JEDI Dispute

Amazon and Oracle's Beef Is Carrying Over to the Courtroom in JEDI Dispute

What Is Litecoin? What to Know in 2019

What Is Litecoin? What to Know in 2019

How to Play Today's Collapse in Oil Prices

How to Play Today's Collapse in Oil Prices

In This Stock Market, It's Not Easy Being Green

In This Stock Market, It's Not Easy Being Green