INVESTING IS OUR STRONG SUIT

A daily column on investing by Orbis Investment Management Limited

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Risks of passive investing

Earlier this week when we wrote about the various styles of investing we categorised the styles into Active and Passive. The Active manager attempts to outperform a benchmark index. The differences between the active portfolio and the benchmark also expose the portfolio to the risk of under performing. In contrast, the Passive manager sits on her hands and tries only to match the performance of the portfolio's benchmark while sometimes keeping expenses low.

During periods when active management styles generate returns that are lower than the market averages, just matching the index becomes more popular. We are in such a period now. In fact, over the last decade indexing has become very popular. The unprecedented bull market in the US has helped to convince investors that they need not pay a manager for active management.

While a passive approach has benefits, there is, however, a significant risk in taking the passive indexing approach. The old adage "Buy Low, Sell High" is not followed by index funds. Just the opposite, as some stocks increase while others decrease over time the index fund matches these changes and ends up holding a larger proportion of the stocks that have done the best and a smaller proportion of those that have under performed. While the trend continues, this works well but when the trend reverses you have a problem.

Consider, for example, what has happened to the weighting of major countries in a worldwide index of equities. In December 1989, Japan had just experienced the most fabulous period of stockmarket gains.

In the late 1980s, Japan was considered to be the powerhouse of future global growth. The rest of the world was trying to re-engineer itself in the Japanese style. General Motors was considered to be a dinosaur. At this most optimistic moment, the Japanese stockmarket represented 42% of the value of investable equities worldwide. This was its highest weighting ever. And it was its most vulnerable moment.

At the beginning of 1990, the Japanese stockmarket bubble burst. The average Japanese share subsequently declined 67% over the following eight and a half years. In August 1998, after this protracted bear market, the value of the Japanese stockmarket constituted only 9% of equities worldwide. It was difficult to find an investor who liked Japan's prospects. Yet this may well mark the bottom of the bear market and is probably the beginning of a new more positive phase for Japan compared to other stockmarkets. Placing 42% of your global portfolio in Japan at the top of the market and only holding 9% at what may well turn out to be its bottom is not Buying Low and Selling High.