Breadth Thrusts & Bread Crusts: A Big Test For Passive Investors

JC Parets
February 17, 2022

From the desk of Willie Delwiche.

I’m reading the book “Trillions” by Robin Wigglesworth right now. It’s about the rise of passive index investing – or, according to its sub-title, “How a band of Wall Street renegades invented the index fund and changed finance forever.” 

It’s been an enjoyable read so far. I’m about halfway through the book and am excited to see how it finishes. 

While Wigglesworth’s book has been written and published, the story of passive investing overall remains unfinished. If it is like other investing fads that have come and gone, some of the most exciting times (for better or worse) may lie ahead. History is littered with investment approaches that move from novelty to seemingly foolproof only to end in heartbreak and tears for those left holding the bag.

Passive proponents will often dismiss volatility as an unavoidable cost for being in the market and benefiting from the returns that can generate. However, this assumes investment risks and returns are normally distributed over time.

They are not. And because returns aren’t normally distributed, there are times when it is beneficial to to actively tilt toward risk assets – as well as times where it makes sense to lean away from those same assets.

Beyond this point, the idea of holding on at all costs and enduring a rough ride is far less appealing if you don’t actually go anywhere. A bumpy train trip that gets you to a favorite destination is easier to put up with than a turn on a rickety roller coaster. Passive investing has benefitted from a strong underlying uptrend in the US for more than a decade. Periods of volatility were brief and large-cap equity indexes were quick to return to new highs. When equities did stumble, bonds were typically there to provide ballast to balanced portfolios.

In other words, passive investing has not been tested. It’s popularity has not been tried in a period like the 1970’s and early 1980’s when both US stocks and bonds experienced drawdowns that were significant in both degree and duration.

That could be changing – and changing rapidly. The Fed is going to move aggressively to fight inflation, raising interest rates and shrinking its balance sheet. This will put downward pressure on bond prices as well the areas of the equity market that have most benefited from a long-term downtrend in bond yields.

Investors are already starting to feel the effects. Static 60/40 portfolios are off to their worst start of the year in the past quarter century. US stocks aren’t the worst in the world so far in 2022 – but they are the worst in the Western Hemisphere. Commodities were the best performing asset class in 2021, and are off to the races again in 2022.

Passive investing leaves little room to learn from and adjust to incoming information, or to adjust allocations in response to new risks and opportunities. When sitting still isn’t the best strategy, it makes sense to move. An open mind and active adaptation is a time-tested growth path.

If the shifts in the investing landscape over the past couple years reflect sustainable trends, the passive investing fad could face its biggest test yet. If the trends of the past decade are not the trends of the coming decade, passive approaches will leave investors disappointed and discouraged with yet another “foolproof” approach that proved to be flawed.

We can’t read about these experiences in a book right now. That part of the story has not yet been written.

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