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How career risk turns many active managers into index trackers

Those who say that passive investing represents the "blind" allocation of capital have a point, says John Stepek. But it's not like active fund managers were very "active" to begin with.

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Jeff Bezos is a bona fide business genius, but the price still matters

One concern I often see levelled at "passive" investing is that it represents "blind" allocation of capital.

If you're investing in an index tracker, you're just buying the index. You aren't paying any attention to whether or not the individual companies are any good or not.

Logically, that seems like a recipe for capital misallocation and bubble production.

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And I don't question that.

However, what I do question is this: how much of the "active" investing being displaced by index tracking, was ever truly active?

Career risk prevents most fund managers from being truly active

There's a great quote in a Wall Street Journal piece by Michael Wursthorn that I read this morning.

One fund manager says of his chats about tech stocks: "I don't talk about multiples. That's where the conversation stops. I tell them, Help me to understand what this business looks like at maturity.'"

I get where he's coming from. Tech stocks are fast-growing and most of them have a lot of different business lines. And it's all about networks and subscriber bases and all the rest of it.

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And to be very clear, these are fantastic companies. Amazon brilliant company, and Jeff Bezos strikes me as a bona fide business genius.

Apple has somehow succeeded in turning a mass consumption electronic device into a luxury item, thus evading the sector-wide problem of tiny profit margins.

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Facebook, I largely can't see the point of, but I'm clearly in a minority, which is rather the point you are almost forced onto its network if you want to maintain contact with certain people. And that's ignoring the fact that it owns plenty of other apps, some of which I do find useful (eg, WhatsApp).

And Google yes, there are other search engines, maps, and email providers. But for now it really is no contest.

Netflix I still struggle with its sustainability, but the company has clearly been doing something right. It's easy to forget that it started out as a mail-order rival to Blockbuster and somehow managed the technological evolution to internet-based broadcaster with barely a mis-step. That's impressive.

Even Tesla, which frankly looks a mess to me, and very near the endgame now, has produced a high-quality product. Whatever else he has done, Elon Musk has helped to make electric cars "cool", thus potentially helping to transform the future of transport and energy consumption on this planet. So that's a good achievement, even if he gets overtaken by big companies who can actually make cars to scale.

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So all interesting, strong companies. But price matters. And when someone starts saying, in effect, "don't talk to me about valuations", then I can't help but get worried.

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Put it this way, do you think the manager would be dismissing price/earnings multiples if they backed up his story, and helped him to justify hanging onto these stocks? I think he'd be more than happy to talk valuations then.

Jeremy Grantham of GMO tells a great story about the 2000 tech bubble which I've repeated here on several occasions in the past. Grantham had stubbornly avoided tech stocks, and was smarting somewhat because he'd lost a lot of clients as a result.

He surveyed a large group of fund managers (about 1,000) and asked them, in effect, if they thought the market was overvalued, and if it was going to crash. Virtually all of them answered "yes" to both questions. But they were hanging on in there, because they knew that if they didn't, their investors would abandon them for rivals who owned all the popular stocks or they'd get fired for falling into the relegation zone at the next quarterly results.

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In effect, career risk the danger that you'll get fired for not keeping up with the index, or taking a big bet that goes wrong (even for a short period of time) keeps many active managers trading as tightly to the index as they can get away with.

Why we like investment trusts

So while I agree that there's certainly an argument to be made that all the money flooding into passive investments might result in some added volatility come the next crash, I'm still hard-pressed to have any issues with passive investing per se. Because at worst, it is displacing money that would have gone into active funds that were little more than closet trackers anyway.

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If you're the sort of person who would once just have bought an active fund because you saw a big billboard with the manager's face plastered over it, and some promising-looking past performance figures, and your financial advisor mentioned it to you in passing then you are still definitely better off buying a passive fund. Because at least it's cheap. And if you're not going to put much thought into what you buy, it might as well be cheap.

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But if you do care about your investments and you should then you're going to need to take a more active approach anyway. As I've already argued last week, there's no such thing as purely "passive" investing anyway. You need to think about where you want your money to go the fund that you then use to implement that choice is the last in a long line of decisions.

So, if you decide to go for an actively-managed fund rather than an index tracker, make sure it's genuinely active. Find a manager who has a well-articulated strategy that makes sense to you and that they stick to, and that they've been running for a while.

Structure-wise, we do like investment trusts they're not perfect, but among other things, they provide some insulation from career risk, because the manager doesn't have to worry about investors requiring refunds en masse (we explain more on investment trusts here).

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If you want exposure to the big tech giants, then you should do what we do in the MoneyWeek investment trust portfolio. Have a portion of your portfolio in a genuinely actively-managed investment trust like Scottish Mortgage Trust (LSE: SMT) that gives you considered, high-conviction exposure to the sector.

That way, you don't feel that you miss out if there are further gains, but you're not staking your entire portfolio on the most popular stocks in the market.

There's also the fact that you are investing alongside managers who were investing in all of this stuff even when it was unpopular (or less popular, at least) so you know that they're not going to make errors based on peer pressure.

I'm out of the office from tomorrow for just under a fortnight, but for the rest of this week, we'll be running a series of articles on investment for beginners. And then next week, as the anniversary of the 2008 crash nears, we'll be taking a look at how things panned out the last time we saw anything similar happen to markets the Great Depression of the 1930s.

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