“It’s Official: Passive Funds Overtake Active Funds.”

In mid-January, I read the above headline, and a small part of me died inside. Okay, I am being a bit dramatic, but I was disappointed. In my opinion, this is a sign that most investors are content to be average.  

By passively buying an index fund, they are making a willful choice to accept the returns and drawdowns of that index. They are willfully choosing to be average. I partially understand the thought process, but that does not sit well with me. 

These investors hide behind concepts such as the efficient market hypothesis, which says that all known information is reflected in the market at all times, so it is hard to beat the market – don’t bother trying.  

The market is mostly efficient but not so much that you should not try to beat it. Just look at the rewards that can accrue to those who put in the effort. Steve Cohen owns the N.Y. Mets after years of proving that the market can be beat. David Tepper owns the Carolina Panthers after years of proving the market can be beat. Finally, everyone’s favorite villain, Ken Griffin, owns the U.S. Constitution after proving…well, you get it. 

You see, I come from a world where people were constantly trying to beat the market either on pure return or risk basis. I was at a sales and trading desk for a decade, covering some of New York City and Connecticut’s largest mutual funds and hedge funds. 

      • I believe in the “stock picker.”  
      • I believe in an active manager who puts in the time and effort to create an edge and attempts to exploit it in the market.  
      • I still believe that the market can be beaten, either on a return, or risk reduction basis; it is just becoming increasingly more difficult. 

“I view the markets as fundamentally broken…” This quote comes from David Einhorn on the Masters in Business podcast in early February. 

It is a bold statement and one with which I take issue. I do not believe the market is broken. I have not had any problems executing orders for the funds at Potomac. However, I agree that the value discovery function of the market has been broken, and passive investing is the one who snapped the bone here. 

Let’s use a simple example. Microsoft Corp. (MSFT) is currently a 7.13% weight in the SPDR S&P 500 ETF Trust (SPY). Visa Inc. (V) is currently at 1.06%. When an investor puts $100 into SPY, they are buying $7.13 worth of MSFT and $1.06 worth of V.  

Has this investor “done the work” on these two companies to conclude that MSFT deserves a 7x allocation in the portfolio relative to V? My guess is no. 

This is what Einhorn means when he says the market is broken.  

No attention is being paid  to the relative merits of each of these companies. And it is being played out at scale: 

Einhorn goes on to note that this dynamic caused his funds to experience poor performance for a five-year stretch. However, he did not throw in the towel, blaming the market for his results. He goes on to discuss how he and his team worked hard to find a way to adapt to this new market reality. 

The biggest takeaway for me from all of this is that picking stocks, while always hard, is getting harder. Passive index investors are not interested in finding value in the market. So, as they pump more money into SPY, they are just pumping more money into the biggest stocks. 

So, what does this have to do with Potomac? Good question. We are not stock pickers. We are not trying to decipher the relative value difference that would justify making MSFT a 7x bigger position in the portfolio than V. 

We are, however, very much an active manager.  

We simply deploy an active strategy using passive products. The main fund inside our Bull Bear strategy takes a concentrated position in a broad passive index fund. However, we only take that position when our composite models tell us that the odds favor doing so. When the odds are not on our side, we are content to hold cash. This allows the strategy to run at a relatively low correlation and beta to the S&P 500 when compared to many passive buy-and-hold strategies. 

In essence, we are using an active strategy on passive products. We are actively passive…or is it passively active? Semantics.  

The point is that we are not content to sit by and accept average. Yes, being average means that you can receive the market’s return. But you also receive the market’s drawdowns. 

In my career, the S&P 500, the Average, has been cut in half twice and recently lost more than one-third of its value. The passive argument assumes that the average investor, in search of the average return, can sit through these drawdowns no matter what.  

I’ll take the other side of that bet. 

Why accept average? 

Potomac Fund Management ("Company") is an SEC-registered investment adviser. SEC registration does not constitute an endorsement of the advisory firm by the SEC nor does it indicate that the advisory firm has attained a particular level of skill or ability. This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page. The company does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to the Company website or incorporated herein, and takes no responsibility for any of this information. The views of the Company are subject to change and the Company is under no obligation to notify you of any changes. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable or equal to any historical performance level.