The way successful investors think

November 17, 2023

Pauls Miklasevics 

Chief Investment Officer (CIO) at BluOr Bank

If everyone is thinking alike, then somebody isn't thinking.

/ General George S. Patton /

You will never get rich through passive investing. Not in markets; not in life. No person that has ever made significant returns in financial markets or made an impact on the world has ever woken up in the morning and said “I want to be average”. Life doesn’t work that way.

Yes, there are certainly many rich passive investors, but passive investment is not the main driver of wealth, but rather how much and how early you invested. The secret is not ‘passive investing’ – its money, time and compounding.

That being said, over the past two decades tens of trillions of dollars have been channeled into passive investment strategies at the expense of active managers. In fact, by the end of this year passively managed mutual funds and ETFs in the United States are set to exceed the money managed by active portfolio managers. This means that over half of a 25 trillion dollar pool of capital will be steered without a second thought into predetermined pools of assets regardless of valuation or technical parameters.

Before we continue, let us define our terms. Passive investing involves buying low cost investment funds (mutual funds or ETFs) that mirror a chosen index such as the S&P 500 equity index or the Bloomberg Barclays Global Aggregate Bond Index.

They are low cost because they do not employ teams of well-paid portfolio managers and analysts, nor do they have the considerable distribution expenses of typical active mutual funds. Instead, they simply pay a license fee to an index provider and hold whatever securities the index is holding. They adjust their holdings whenever the underlying indices rebalance, which can be on a quarterly basis or more seldom. This also reduces trading costs.

Actively managed funds are run by portfolio managers who use a variety of valuation parameters, research and market timing to select investments that they believe will beat the returns of the index that they have chosen as their benchmark after they have taken their fees.

Life used to be grand for active managers. As pools of capital grew over the second half of the last century more and more money flowed into the portfolios of mutual fund managers in the developed world. There was no better alternative for a professionally managed, diversified investment product that you could invest in incrementally. Mutual fund sales flourished. 

Fundamentally, the business of these companies was to be good stewards of their client assets, but there were several levels of the game-within-the-game. Top performing mutual funds would engage in massive marketing spending and draw in hundreds of millions if not billions of client money – elite managers such as Peter Lynch were feted like rock stars and became household names. They were also treated as uber-VIPs by brokerage firms who wanted to attract their trading revenues – no expense was spared. None.

Mutual funds were selling the promise of future returns, but shrewdly locking in client money for up to seven years through deferred sales fees as part of the bargain. These sales fees enabled fund companies to lavish top sales people with extravagant prizes and pay packages for hitting top percentile targets. Everyone was making money. This might sound blasphemous to acolytes of passive investing, but so too were the actual clients. It turns out that locking in money for long periods of time actually tended to be very beneficial to mutual fund holders.

Amidst all this euphoria and moneymaking delight something happened: it was disrupted by capitalism and innovation.

On December 31st, 1976 Jack Bogle Vanguard launched their first index fund. At first he was mocked - no one could imagine how he could make money. But Vanguard kept growing even though it took over 25 years to capture the popular imagination of investors just after the turn of the millennium.

Up until then, active managers had not really taken the threat of passive investing seriously. Sure, they were benchmarked to an index, but if not one could buy the index, then all they were doing was competing with each other. Also, if you attracted money that had high break-up fees for the next 7 years, surely you could find a period of time during that timeframe to outperform again and attract a new flood of money. 

It turns out that active managers should have been paying more attention because proponents of passive investing began publishing studies that showed how high fees (everybody was doing it!) and a normal set of probability outcomes resulted in over 75% of managers underperforming their index. By the time these studies were published the threat of passive investing was all too clear.

Fortunately for active managers, many investors tend to be complacent. Knowing this, they pivoted strategies. The game was no longer about beating other managers. Now the danger was losing to the index. So many of the largest managers engaged in closet indexing. Closet indexing means constructing portfolios that basically mirror the index with slight over and underweights in individual positions that ostensibly ensures that your performance will never drastically under-perform – or over-perform – your chosen index. But you could still collect nice management fees while your marketing team worked hard to convey to clients that you had an eminently talented manager at the wheel that could steer your free of danger if indexes we to do something cataclysmic. This also worked very well for a while.

And then something cataclysmic actually happened - the Great Financial Crisis - and precious few actively managed funds actually steered clear of danger. This is when the real money began to flow into passive strategies, which – conveniently - coincided with the most substantial spell of monetary easing of all time. Free money dumped into index strategies created a veritable victory procession for passive investors. Yet let us remember that triumphant roman generals during their victory processions were followed by slaves that whispered ‘memento mori’ (thou too shalt die).

Romans loved to celebrate their military victories, but were keenly aware that overconfident generals could jeopardize the Republic. Success was to be aspired towards, but overconfidence could unravel all previous successes.

Passive investing has been a very successful strategy since the GFC, but all strategies expire; all empires fall. And not everyone that is in competition with passive investing has accepted defeat. I was recently in London for an investment conference hosted by one of the world’s foremost active asset management companies - Schroders. They very much realize that their past business model is under threat and are ready for battle.

Faced with a monolithic, passive adversary they are putting an emphasis on leadership – both in terms of identifying critical investment themes and playing their part as responsible stewards of capital to help guide their portfolio investments to a sustainable future. They are also positioning themselves as beneficent gatekeepers to private asset classes that are not currently accessible through passive strategies. This is being done at a time that passive investing has become quite top heavy. More money than ever before has amassed in the biggest seven companies in the S&P500 index resulting in very rich valuations despite a relative decline in revenues. This is not an ideal set-up for future returns.

Moreover, passive investors have prided themselves on diversification. How diversified can you claim to be if only seven companies represent almost one third of the S&P 500?

Is active management about to launch an epic comeback versus passive strategies?

Only time will tell but the next decade promises to change investing as we know it. 

The Latvian version of this article originally appeared in the November 2023 issue of Forbes Latvia.