Passive Investing Looks Easy – Until Markets Stop Rising

Right now, it’s easy to make a case for passive investing.

Global equity markets have delivered exceptional returns, led by US technology companies and extraordinary enthusiasm around artificial intelligence. South African equities have also performed strongly, helped by precious metal and resource shares. Join the dots backwards and the conclusion seems obvious… don’t pay for active investment management – simply buy the index cheaply, and enjoy the returns.

The problem is that investing is rarely that simple, especially longer-term

History has repeatedly shown that markets can become expensive, concentrated and overly optimistic. When that happens, a passive fund does not ask whether the largest shares in an index are expensive. It simply keeps them in the portfolio because they are included in the index.

That doesn’t make passive investing bad. Passive investments provide efficient, diversified and low-cost market exposure and at Netto Invest we recognise and use them as a valuable part of the investment mix. However, low cost should never be confused with low risk.

Because passive investing also requires… patience

When markets are running hot, patience is something one may underestimate as an investor. When you plan to buy the market, you must be ready to own it through the bad times as well as the good. That means accepting the possibility of substantial falls in value and periods when overall investment returns will disappoint. 

Buying an index is the easy part; staying invested takes grit

The explosion in Exchange Traded Funds (ETFs) makes this principle even more important. Today, an investor can buy an ETF specific to almost any sector, geographic area or investment theme you can imagine. Inevitably, new investment products are created around the themes that are currently attracting attention and money. 

But if you are buying specific themed ETFs, how “passive” is that?

There is a significant difference between using passive investments as strategic building blocks within a diversified portfolio versus buying the latest themed ETF because its underlying assets have just delivered spectacular returns.

In addition, there is also an uncomfortable truth about passive investing: at a portfolio level, it isn’t passive at all.

Portfolios don’t manage themselves

Someone still needs to make the decisions about how much to invest locally and offshore. How much should be in equities? How much in developed versus emerging markets? Should the portfolio own a higher proportion of US equities after their strong run, or diversify elsewhere? How and when should the portfolio be rebalanced?

All of these are active investment decisions.

At Netto Invest, we don’t view active and passive investing as opposing philosophies

We routinely use both: 

• Passive investments can provide efficient market exposure.
• Established active managers can bring different investment approaches, valuation disciplines and diversification when markets become more difficult.

Our objective is not to advocate for the investment strategy that has the easiest story today. It is to construct a diversified portfolio capable of delivering sustainable returns through different market cycles and, critically, portfolios that you as a client can remain invested in, even when conditions become less rosy.

After all, the real test of an investment strategy isn’t how good it looks when market values are climbing. It’s whether you can stick with that strategy when they don’t climb.

Michael Maré, CFP® FPSA®
B.Com