- Passive investing has been excellent in the past decade but has gone nowhere in the last two years.
- Higher valuations are increasing volatility and risk which gives opportunities for more active strategies.
- Due to the high valuations in 1968, only an active strategy would have produced positive returns in the period up to 1982.
The S&P 500 has gone nowhere since December 2014. Several reasons have influenced such a performance, but the most impactful factors seem to be market fundamentals deteriorating while central banks keep limiting the downside by increasing available liquidity. The FED was supposed to begin raising interest rates, but the 0.25% hike was insignificant, and now there is even speculation that the FED could lower interest rates again.
In such an environment you might wonder if the old buy and hold strategy is the best or if you should be more active and seize the opportunities given by the volatility in the market.
Figure 1: S&P sideways movement in last 12 months. Source: Bloomberg. Annotations: Author’s own.
This article is going to analyze the benefits and risks of both a passive and active strategy, and relate them to the current market.
A passive strategy is one that promotes “buy and hold no matter what” because stocks should always outperform all other assets. Passive strategies include investing in mutual funds or reinvesting your dividends in the stocks that issued them and not thinking much about what is going on in the market, the valuation you are paying, or the risks.
The passive strategy has been developed from the Efficient Market Hypothesis which states that it would be impossible to know something about a security that would improve your returns as the current price already incorporates all available information about the security, and only by knowing something that no one else knows would it be possible achieve extra returns.
This idea has been promoted in the last few years as the S&P 500 bull market created a situation where over the five-year period, 84.15% of large-cap managers, 76.69% of mid-cap managers, and 90.13% of small-cap managers lagged their respective benchmarks in the U.S. You might wonder, if more than 80% of the professional managers did not manage to beat the market, why should you try? Well, passive strategies are good, but the only return in the S&P 500 since December 2014 would be coming from the dividend yield, which is currently at 2.12%.
But the Efficient Market Hypothesis would have you buy without thinking about what might be the cause of such an historic rise in stock prices, which has been the high liquidity provided by the FED. Buying without thinking makes investors disregard valuations, and high valuations bring much higher risks and lower yields.
Figure 2: S&P PE ratio since 2011. Source: Quandl.
As you can see, the S&P 500 PE ratio went from below 13 in October 2011 to the current 24 which is an 84% increase. At the same time, the S&P 500 increased by 82% which means that there were no fundamental changes and investors are now willing to pay almost double the price they were paying 5 years ago for the same yields.
Figure 3: S&P 500 since 2011. Source: Bloomberg.
You should ask yourself if you are happy just doing what the crowd is doing, or if you want to have your risks properly assessed and maybe even outperform the market in the next few years. As the current bull run is mostly influenced by optimism and higher risk acceptance, we can only imagine what would happen if the risk perception changes and all of these passive investors start selling.
We have seen a few glimpses of what can happen in the three sharp declines we have witnessed in the last 12 months. If you think the current market is overvalued or going nowhere for a longer period of time, you could think of an active strategy. Don’t forget that stocks do not always go up, from 1968 to 1982 the stock market also moved sideways due to the high valuations reached in 1968.
In a flat market, investors are tempted to do something in order to increase their returns. This does not mean that investors should take crazy risks like shorting or trading options, active investing could also just mean to reallocating your portfolio weights in relation to the risks those assets carry.
You might wonder how to assess the risk. Well, the usual academic option is to calculate an asset’s volatility, but the logical way is just to check the yield of the asset and its price. If we start from the premise that risk is a function of price and not volatility, the higher the price of an asset is, without any changes in underlying fundamentals, the riskier the asset. As the S&P 500 has seen only deteriorating fundamentals in the last two years and earnings did not grow as much as asset prices, we could say that stocks are much riskier now than they were 7 years ago, even if they were much more volatile in 2009.
Cyclical stocks are a great example of how and active strategy can seize the opportunities given by the market. Daimler, the company that manufactures Mercedes luxury cars and other vehicles, is the perfect example.
Figure 4: Daimler (OTC: DDAIF) price movements since 1998. Source: Yahoo Finance.
The long term swings are very clear and those are swings of more than 100% up or 75% down, so they give plenty of opportunity. Now, if you think that such a company will be around for a longer time you do not have to just buy and hold, you can buy more and increase your exposure when prices are down, and lower your exposure when prices are high. This is difficult to do as you have to do the opposite of what fear and greed are telling you, but in the long term such a strategy would decrease your risks and probably also increase your returns.
There will always be a debate between active and passive managers about which strategy is better. As a smart investor you might want to be passive when valuations are low and more active when valuations are high in order to minimize your risks and maximize your returns. It takes some effort and a correct mindset to sell when everyone is buying and buy when everyone is selling, but such a strategy will create the extra returns.