Why Investing in Passive Products Doesn’t Make You a Passive Investor

So-called passive investing products like exchange-traded funds (ETFs)—which track particular segments of the equity market or the market as a whole—have gained popularity in Europe recently. We have seen much financial commentary describing this as a rise in passive investing—buying funds that mirror the entire equity market and holding them for the duration of your investment endeavours, rather than actively trading individual shares. But in Fisher Investments UK view, passive products don’t always make for passive investing. We have found many investors use passive products quite actively—leaving them exposed to the same errors that we think often thwart active investors.

Passive investing advocates contend markets are highly efficient—meaning they reflect publicly available information in prices almost immediately. They say that makes markets exceptionally hard for investors to outperform with any regularity, rendering active investing—the use of strategies intended to outperform broad markets—problematic. Passive investing proponents say investors who try to pick individual shares or otherwise invest actively often make poor decisions, slamming their long-term returns.ⁱ Or they say many investors pay active money managers exorbitantly high fees—meaning the investor can lag the broader market even if the manager beats the market’s return. According to passive investing proponents, investors are better off buying low-fee index funds that track the entire equity market. By passively owning a piece of the entire market in perpetuity rather than actively buying and selling individual equities, investors eliminate the possibility of poor—and costly—trading decisions, the theory goes.

But we have found many allegedly passive ETFs gaining popularity are far more narrowly focused than broad market indexes—making the mere act of picking one over another an active decision, in our view. Many ETFs focus on shares from a particular market segment.ⁱⁱ Some, for example, include only shares of large-capitalisation firms, typically defined as those whose market capitalisations—the value of all their shares outstanding—are over about £7.8 billion.ⁱⁱⁱ Others focus on smaller firms. Similarly, certain ETFs include only shares of value equities—those trading at relatively low prices compared to underlying business measures, like sales or earnings. Others exclusively invest in growth firms—those that are expanding rapidly and typically trade at higher prices compared to business measures. Some ETFs focus only on a particular region, country, sector or industry, or some combination thereof, whilst still others target specific themes, like trends in high-technology products or shares the fund designer hopes will provide less-volatile returns than most. In these cases, the fund designer simply creates an index for their new fund to mirror.

When buying these types of ETFs, investors are not passively mirroring the entire equity market—they are actively deciding to eschew certain categories for others, or emphasise them in manners that may not reflect broad markets. This opens the possibility for bad decisions to leave their portfolios significantly lagging the broader market’s returns—exactly what passive investing is supposed to prevent.

Moreover, we have found many seemingly passive investors don’t stick with a fund—they trade frequently. Indeed, a commonly cited part of ETFs’ allure is their listing on exchanges, allowing investors to trade them as they would a single company’s shares.^iv In our view, this suggests ETFs aren’t designed to be held long term—potentially making investors more likely to use them actively than passively.

Our examination of ETF fund flows—the difference between how much is collectively added to funds versus withdrawn in a given period—indicates investors do actively trade ETFs, sometimes at inopportune times. Consider US data for America’s more robust ETF history. In January 2019, investors pulled a net -£16.1 billion from US equity ETFs—a record amount since our data began in 2006.^v But that was just after equities had already started to recover from sharp late-2018 declines. Now, fund flows don’t show what investors do with the proceeds from selling—they could reinvest them in other equity funds or individual shares. But those who sold in January and did not reinvest in equities missed part or all of a 2019 in which US equities soared 23.9%.^vi Similarly, European investors collectively pulled nearly -£11.5 billion from equity ETFs amid coronavirus fears in March 2020—the same month equities started to rebound from their winter plunge.^vii

We think those examples indicate ETF traders trade frequently and can fall prey to the same behavioural biases that cause many traders of individual shares to buy high and sell low. Because it involves owning the whole market in perpetuity, passive investing is theoretically supposed to protect investors from these mistakes. But ETF investors who actively trade funds aren’t investing passively, in our view—they are merely practising active investing without choosing which individual shares to own. We find no evidence investors are any better at picking funds than they are at picking individual equities.

Investment products billed as passive aren’t necessarily bad choices, in Fisher Investments UK view. But we think investors benefit from understanding that ETFs are not inherently passive. They are merely products. In our view, when investors use them actively, they do not garner the purported benefits of passive investing.