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Question from Globe and Mail reader Peter: With all the hype surrounding passive investing, is it possible to lose in this strategy? What if the Japanese ‘lost decade’ were to happen to Canada or the U.S.? Is that possible? How would a passive investor’s return look in that case?

Answer from Darryl Brown, an independent investment consultant and founder of You&Yours Financial. He is also director of portfolio strategies at Spring Planning:

For the past several years, there has been a lot of hype around passive investment products, more commonly known as index funds or exchange-traded funds (ETFs).

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Compared with “active” or more traditional investment products such as mutual funds, where a portfolio manager hand-picks certain companies to invest in, ETFs select a methodology and invest in a broad basket of companies. For example, an ETF may invest in the 250 or so large companies that make up the S&P/TSX Composite Index, or in a broad basket of large Canadian dividend-paying companies.

Darryl Brown, investment planner and founder of You&Yours Financial in Toronto.

Handout/Handout

An actively managed investment product will usually have fees in the 1 to 2 per cent range, where an ETF will have fees of only 0.05 to 0.35 per cent. On a $50,000 portfolio, moving from 2 per cent to a much lower ETF fee would put almost $1,000 back into your pocket, each year.

The move into ETFs and passive investing has really opened the door for investors to own a well diversified portfolio of companies at a fraction of the cost. In this regard, the hype is well deserved.

But, like all investments, there is potentially a downside. In exchange for owning a broad basket of companies at a very low cost, investors are exposed to the overall moves of the market which, depending on the selected ETF, can include the performance of hundreds, if not thousands, of companies.

Additionally, there can be periods of time where stock markets trend downwards. Referred to as “bear markets,” such periods pose a huge challenge for passive investment strategies and passive investment products. Is it possible to lose in this strategy? Well, the short answer is yes, it’s definitely possible to lose.

A period of widespread and prolonged market underperformance like the Japanese “lost decade,” which was actually closer to two decades, is absolutely an example of when passive investing could suffer. In a declining market, individual company selection could at least give you the prospect of achieving better risk-adjusted returns.

Even with a steady market rise since 2009, a trend has started to emerge where outsized investment gains are coming from a smaller subset of companies. With the onset of the COVID-19 pandemic, this trend is now glaring.

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For example, the passive S&P 500 ETF has not “lost” money in 2020. In absolute terms, the return is positive but relative to some individual companies included in that index, the broad index has massively underperformed.

While Amazon, Apple, Alphabet, Facebook and Microsoft had returned, on average, about 35 per cent through the summer, the remaining stocks on the S&P 500 have collectively declined by 5.1 per cent. Said another way, five companies performed well enough to lift the entire S&P 500 index into positive performance for the year.

Although it’s impossible to consistently select which of those companies will outperform, it does bring into question whether individual stock selection deserves more credit, especially in recent years.

We’ve seen the COVID-19 pandemic accelerate many trends that were already in place, such as remote working. The re-emergence of individual stock selection as a solution for investors could be another trend accelerated by the pandemic.

At the moment, the picture for the broader market is murky with the economic recovery slowing, perhaps already stalled, significant amounts of household and corporate debt, political gridlock resulting in slow or inadequate fiscal measures, and the ongoing U.S. led trade war.

These are all negatives from an economic standpoint. You asked whether a lost decade could happen in Canada or the U.S.? I can’t say for certain but I think 2020 has shown us that anything is possible. If our broader financial markets connect with the above realities, we do know that the performance of broad, passive investment strategies will be negatively affected.

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What I do know is we’re in a market where we could start to see the divergence in the performance of:

  • The largest companies, which benefit from global platforms, scale and low-cost of capital;
  • Small, nimble companies, which could benefit from emerging opportunities in a post-COVID world;
  • Companies in the middle, which have legacy businesses that may make it difficult to do either.

Globalization, innovation, labour force growth and supportive interest rates have provided an incredible lift to North American stock markets since the global financial crisis and a very popular saying in the investing world is “a rising tide lifts all ships.” The question that will matter most to the debate over active versus passive investing is whether the tide is still rising.

Darryl Brown is an independent investment consultant and founder of You&Yours Financial in Toronto.

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