There has been a growing trend over the last decade to passive investing. With their low cost, transparency and instant diversification they are a one-stop solution. Even the great Warren Buffet has suggested: “The goal of the non-professional should not be to pick winners but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
At Bristol Gate, we are also believers in passive investing, but it should be done so with caution and is best when combined with quality, high active share active management.
The Unintended Consequences of Passive Investing
- You are not as diversified as you think
Passive index ETFs broadly buy the entire market. However, not all markets are created equally and depending on which passive strategy you buy you are actually making unintended bets. As an example, the S&P500 Low Volatility index is generally over 20% invested in Utilities and the S&P 500 itself has generally had over 20% exposure to Technology. The result is that even though you believe you are diversified, you are really reliant on the performance of these dominant sectors and sensitive to the risks of them as well.
- All the upside, but all the downside
Passive investing gives you perfect market exposure. This works when markets are going up because you get almost all of the upside however, when markets turn you accept all of the downside as well. There is no protection in a passive portfolio.
- Tough to beat the market, when you are buying it
If you are buying perfect market exposure, then there is no way that you will be able to outperform the market. In order to beat the market, your portfolio must be different from the market and either outperform on the upside, downside or both.
Working together for better outcomes
The combination of active management and passive investing is a powerful concept. The balance of both approaches can help achieve the goals of outperforming the market while keeping costs down.
The key when blending active and passive is having an active manager that looks different than the market. Otherwise there will be too much duplication over the passive index. This can be measured by whether a portfolio has a high active share.
Often active portfolios will be tilted to certain factors (ex. Momentum, Value, Low Volatility) which by including over with a passive portfolio will tilt your portfolio that way as well. In the case of Bristol Gate, we tend to tilt towards quality because the type of companies that can grow their dividends at upward of 15% will have strong balance sheets and capital allocation discipline.
Key Concept: Active Share
The percentage of fund holdings that is different from the benchmark holdings. A fund that has no holdings in common with the benchmark will have an Active Share of 100%, and a fund that has exactly the same holdings as the benchmark considered will have an Active Share of 0%.