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4 key (but tough) truths about passive investing

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The explosive popularity of passive investing shows no sign of cooling any time soon, but perhaps it should.

During the first seven months this year, investors poured $391 billion into ETFs, already surpassing the record set in 2016. Although passive index products do have a place in many portfolios, investors’ overreliance on them could have devastating consequences.

Here are five tough but important truths about passive investing:

1. Passive index products are designed to replicate an index, and their symmetrical returns work both ways. Investors champion passive index products during bull markets because their price rises with the markets. However, the symmetry investors love so much on the way up is what causes the most financial harm in a bear market, defined as a downturn of 20% or more from the market’s peak that lasts at least two months.

In bear markets, passive products, which don’t provide any risk mitigation, can fall just as much as the index, often as much as 50% or more, as the markets did during the crashes of 2000 and 2008. Historically, these bear market losses are seven times more powerful than bull market gains.

2. Passive investing has created a liquidity trap that could cause a recession on par with the 2008 financial crisis. Financial information is instantly disseminated for free via the internet to investors. Although there are many benefits to the democratization of information, it has also synchronized investor behavioral biases, making markets more susceptible to major shifts in investor psychology.

One of the most dangerous indicators of a market top is crowded trading. The rush to passive index products points to the possibility that future bear market cycles will be faster-developing, deeper and more damaging than previous cycles.

When investors downshift from the excessive optimism that exists now to pessimism, the ensuing move to sell overpriced assets could cause another liquidity trap even more severe than the one created by the financial crisis.

3. We learned some important lessons from the financial crisis, but 10 years later, we seem to have forgotten them. After 2008’s battering losses, investors changed their approach from chasing returns to focusing on preventing losses. The investment management community responded by creating portfolio concepts with active risk mitigation at the core of their offerings.

They were on the right track, but risk-managed, active strategies have fallen out of favor since we have not had a bear market correction in eight years. However, warning signs that a market downturn or recession could be imminent started with the 2010 Flash Crash, followed by the quick sell-off of risk assets in August and September of 2015 and again in January and February of 2016.

In all these instances, regulators and the Federal Reserve intervened, but they can’t stave off a market correction forever.

4. Investors left to their own devices often play the loser’s game. Another unfortunate side effect of the widespread availability of financial information is investors think that they win at the stock market by themselves. What they don’t understand is their emotional biases drive them to repeatedly buy high and sell low as the market cycles rotate through normal bull to bear trends.

This approach causes them to incur large losses and miss the most powerful bull market returns provided by early bull market recovery rallies.

Investors desperately need advisors, many of whom have been forced to lower fees and, in some cases, have been driven out of business by the enduring popularity of passive management. Advisors need to communicate to clients that protecting capital from large losses, not chasing returns, is the most important factor in achieving their investment goals.

Advisors must implement constant goal tracking, education and reinforcement so that clients stick with the program and don’t let changing market conditions affect their emotions. Most importantly, clients need to understand that the investing game has gotten harder to win in this liquidity-driven market and faster and deeper market corrections may be the new normal.

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