Skip to Content

Herding towards passive

November 2016

By Kajanga Kulatunga, Portfolio Specialist, NAB Asset Management

“Suppose everyone thought the same way you do?” “Then I’d be a damn fool to think any different”.
Dobbs and Yossarian, ‘Catch-22’, 1970.

The popular trend towards funds that passively track a broad market benchmark is the latest episode in a consistent human desire to herd and follow trends set by others similar to us.

While keeping costs manageable is a key investor consideration, especially at times when returns are hard to come by and active stock pickers have had a challenging time, the often ignored and misunderstood risk present in widely available passive funds should make investors cautious. The two obvious risks are that:

  • passive strategies do not provide the full array of investible assets; and
  • most market capitalisation based passive strategies are banking on yesterday’s winners continuing to be tomorrow’s champions.

The instinct to herd (do what others similar to us are doing) is a natural human phenomenon. It stems from our desire to seek safety when uncertain and had a practical use, keeping us safe during our nomadic existence as a species.

The human brain is wired to repeat successful behaviours. The brain releases a chemical called dopamine, which gives a feeling of reward for success in our endeavours. We learn those activities that bring success and feelings of reward and keep repeating them in order to achieve wellbeing.1 This learning system evolved to help animals, including our ancestors, survive and replicate.

Learning works well in some settings, especially where the feedback when doing an activity is immediate, and cause and effect can easily be identified – say learning to deliver a serve in tennis. This same learning system allows us to work hard towards abstract goals even when we have no intrinsic motivation for the task.2 Unfortunately financial markets do not provide a good learning environment as the feedback is often driven by factors beyond our control. Our tendency to herd brings about one of the worst outcomes in investing, that of ‘return chasing’ behaviour.

Herding is a prevalent and costly behaviour in financial markets. As evidenced by the Dalbar study in Chart 1, investors find it hard to find good opportunities before news is priced in to an asset. At every major inflection point in investment markets, the majority of investors are precisely wrong.

Chart 1: Long-term annualized returns S&P 500 vs average equity fund investor

Source: Quantitative analysis of investor behavior, Dalbar, 2016

Outcomes should matter more than costs to individual investors. What’s the point of investing in the cheapest strategy only to realise you are short of funds to achieve your objectives? Investors may be better served by focusing on building a portfolio of assets, employing a skilled active asset allocator who can provide exposure to multiple risk factors (which generate returns) that can perform in a range of market scenarios. Once the portfolio framework is in place, the choice between an active or passive investment strategy to play a specific role in the portfolio should come down to various trade-offs in risk and return profiles of the underlying collection of assets.

For example, private equity or alternative assets are excellent portfolio diversifiers that can’t be obtained via low-cost passive strategies. Inclusion of them may require some traditional asset classes being accessed via tailor-made passive strategies that avoid the pitfalls of herding in order to keep overall portfolio costs low. Passive investing can reflect active views – if used as building blocks, designed uniquely to achieve a portfolio objective.

The current industry debate on active vs passive investing is badly phrased and confuses investors and intermediaries. The real debate isn’t about the efficacy of one approach, as can be seen by the use of passive strategies to implement active asset allocation decisions. It’s about meeting client objectives in a low return world. The active side is arguing the importance of harnessing returns that may be expensive to generate, while some manufacturers of passive strategies are of the view that cutting costs remains the only way.

The solution for clients may be to use the best of both worlds. Simply parking your money in market capitalisation based index funds because they are cheap means you run the risk of being just another fad. 

 

1. ‘Predictive reward signal of dopamine neurons’, Schultz W, Journal of Neurophysiology, 80(1), 1-27, 1998. 

2. ‘Discrete coding of reward probability and uncertainty by dopamine neurons’, Fiorillo CD, Tobler PN and Schultz W, Science, 299(5614), 2003.

 

Important Information

This publication is issued by nabInvest Capital Partners Pty Limited (ABN 44 106 427 472, AFSL 308953) (“NCP”), a member of the National Australia Bank Limited (ABN 12 004 044 937, AFSL 230686) (“NAB”) group of companies (“NAB Group”). An investment in any product or service referred to in this publication  does not represent a deposit or liability of, and is not guaranteed by, NAB or any other member of the NAB Group.

This information may constitute general advice. It has been prepared without taking account of an investor’s objectives, financial situation or needs and because of that an investor should, before acting on the advice, consider the appropriateness of the advice having regard to their personal objectives, financial situation and needs.

Any opinions expressed in this document constitute NCP’s judgement at the time of issue and are subject to change. NCP believes that the information contained in this publication is correct and that any estimates, opinions, forecasts, conclusions or recommendations are reasonably held or made as at the time of compilation. However, no warranty is made as to the accuracy or reliability of this information (which may change without notice) and actual events may vary materially.

NCP relies on third parties to provide certain information and is not responsible for its accuracy. NCP is not liable for any loss arising from any person relying on information provided by third parties.

Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market. Any forecast or forward looking statement in this article is provided for information purposes only. No representation is made as to the accuracy or reasonableness of any such forecast or statement or that it will be met. Actual events may vary materially.

This information is directed to and prepared for Australian residents only.