Why Passive Indexing Is a Bad Bet as Global Conditions Weaken

Passive indexing has been all the rage for the past 10 years as U.S. Federal Reserve and central bank policy intervention around the world has unleashed one of the longest bull markets on record. Sure Q4 of 2018 pushed many indexes into bear market territory for a short while, but the venerated S&P 500 Index avoided the bear market slide with a one-day wonder on December 26th as Santa finally saved the S&P’s bull market trend from the clutches of the Grinch. That rally ignited a melt up for the start of 2019 the likes of which hasn’t been seen in 4 or 5 decades. 

Unfortunately, this rally is built on the same shaky foundation of Fed support and wishful thinking that has sustained “Goldilocks” conditions for the last decade. The markets are continuing to float on hope that the Fed won’t raise rates, will slow balance sheet reduction, and even begin to cut rates again to support the economy and markets. Investors are hoping the U.S. will avoid being dragged into recession by faltering global economies; trade wars and tariffs will be resolved quickly and positively; China, Asia, emerging markets and Europe somehow won’t continue to weaken and will somehow avoid recession and crisis; Great Britain will gain positive resolution on Brexit with EU trading partners and will reverse its growth contraction trend… You get the idea, just close your eyes and hope — don’t worry be happy!

Basing your investment and retirement futures on hope is a really bad strategy and yet the passive indexing wave is only getting stronger for those investors enamored with chasing returns. Traditional passive indexing has gained tremendous popularity as the 10-year bull market has made investing look easy. And it’s low cost so what could be better? The Achilles Heel of passive indexing products is often the symmetrical return profile to the index they replicate. While good in a bull market, synchronization can turn into a really bad bet for investors in a bear market. According to our research, bear market losses have been seven times more powerful than bull market gains and we believe determines whether an investor will fail or succeed.1

The declines of Q4 2018 for indexes that barely dipped into bear market territory are of the kindergarten variety and are also relatively rare historically. Bear markets can force investors to face declines of 40-50% or more, like the 2000-2002 and 2008-2009 bear trends that pushed the S&P 500 down 50% and 57%, respectively.2 Capital losses of this magnitude can cause investors to bail on buy and hold passive strategies. They not only lock in big losses, but they will typically sit on the sidelines in cash or fixed income too long and miss the strong bull market recovery rallies off the bottom. Investors tend to buy high and sell low instead of the opposite, which is needed for investing success.

Capital Economics, one of the leading economic forecasting firms in the world, summed the current environment up as follows:

“With the global outlook continuing to darken, the U.S. had until recently remained a relative bright spot. But the latest data suggest that outperformance may have been short-lived. January’s drop in manufacturing output, led by weaker auto production, suggests that the U.S. is succumbing to the global industrial slowdown.” 

Investors seduced by the idea of low cost in a market environment that has looked easy may be in for a rude awakening. Even if the index product had a 0% fee it’s a bad bargain if it drops 50% with the markets. If it were to take the index 10 years to get back to even, a strategy that can trim losses in a big decline to 10% would be 40% or 4% per year, cheaper. Sometimes the markets can make you believe investing is easy, but unfortunately, it never is and now is the time to move away from chasing return and instead, focus on preserving capital and the gains already achieved. 

Smart Beta products that qualify as passive but provide quarterly rebalancing should be a better alternative to a static passive indexing approach. We think they are likely to perform better in the years ahead if they have a multi-factor, fundamentally biased, stock selection approach. This can dramatically improve security selection and performance over a passive collection of stocks that are capitalization-weighted like the S&P 500 Index. We’d recommend pairing a Smart Beta product approach with an actively risk-managed strategy that can potentially keep losses to a minimum in the event Goldilocks gets eaten by the third major bear market of the 21st century. 

WBI’s Bull|Bear approach to investment management can be combined with a growing number of WBI Power Factor?strategies in an effort to reduce risk, losses, and improve return should market conditions begin to favor normal bull and bear market cycles.

 Important Information

Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr., and should not be construed as investment advice. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request. 

You are not permitted to publish, transmit, or otherwise reproduce this information, in whole or in part, in any format to any third party without the express written consent of WBI Investments, Inc.

SOURCES

1 Schreiber, Jr. Don. “The Ugly Truth About Buy & Hold”. WBI Investments. April. 13. 2018

2 “How to Face the Next Bear Market With Confidence.” usfunds.com. Web. 27 Jun. 2018.