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Active Investing vs Passive ETFs: What’s Best During Stagflation?

stock-chart-Active-Investing-Passive

With investing, it’s important to know what your options are. You could take the traditional route and invest in mutual funds, or you could opt for the more modern approach of passive investing via Exchange-traded funds (ETFs). But which one is better?

The debate of active mutual fund management versus passive ETFs has been raging on for years. Mutual funds have the potential to outperform passive ETFs, but that depends on the fund manager’s skill and expertise and the time frame. On the other hand, passive ETFs offer a low-cost alternative that can be attractive for investors who don’t want to take on too much risk.

If you’re trying to decide between mutual funds and ETFs, it’s important to consider your comfort level with risk and how much time you want to devote to managing your investments. A financial advisor can help you navigate the options and make an informed decision about your investment strategy.

Definition of active and passive investing

Active investing: An investing strategy that involves actively managing a portfolio by regularly buying and selling investments to achieve a desired return.

Passive investing: An investing strategy that involves buying and holding a portfolio of investments for a long period of time with the goal of tracking the performance of a specific index or benchmark.

Stagflation

Definition of stagflation

Stagflation is an economic condition characterized by high inflation and slow economic growth, or stagnation. It is similar to inflation in that it results in an increase in prices, but it is different in that it also includes a period of slow economic growth and possibly high unemployment.

Historical examples of stagflation

Stagflation is associated with the 1970s in the US, but what other examples are there?

  1. Canada experienced stagflation during the early 1980s, when high unemployment coincided with a sharp rise in inflation.
  2. The United Kingdom underwent a period of stagflation in the late 1970s and early 1980s, due to a combination of high unemployment and rising prices.
  3. Japan experienced stagflation in the 1990s after its asset price bubble burst, leading to high inflation and sluggish economic growth.
  4. India suffered from stagflation in the early 2000s, when rising inflation was coupled with weak economic growth.
  5. South Africa experienced stagflation in the early 2000s, with a decline in economic activity and an increase in the cost of living.

Not surprisingly, many of the western economies suffered stagflation in the 1970s and early 80s due to the middle east oil embargo and the US dollar being free to float after Nixon abandoned the gold standard in 1971.

Impact of stagflation on the stock market

During stagflation, certain sectors, such as consumer staples, utilities and healthcare, tend to outperform. Average volatility usually increases during periods of stagflation, as investors respond to changing economic conditions and become more risk averse and uncertain of the future macroeconomic environment.

Stocks that tend to do poorly in stagflationary environments include high-growth stocks and those tied to cyclical industries, such as automobiles and construction materials as well as those that are sensitive to inflation, such as consumer discretionary stocks.

De-Globalization

Definition of de-globalization

De-globalization is the process of reversing the effects of globalization – where global economies, businesses, and cultures become more interconnected or interdependent. This typically involves decreasing international trade and investment, increased economic protectionism, and a decrease in the movement of people between countries. These changes can have a significant impact on the supply chain and prices of products and services.

Historical examples of de-globalization

  1. The World Wars (WWI 1914-1918, WWII 1939-1945): During these wars, many countries imposed restrictions on international trade and financial flows, leading to a significant decline in global trade and economic activity. This caused a decrease in global wealth and standards of living, as well as a disruption in global supply chains.
  2. The Great Depression (1929-1939) : During this period of de-globalization, global trade declined by over 50%, leading to sharp declines in economic activity and high levels of unemployment. This was mainly due to the imposition of protectionist policies such as the Smoot-Hawley Tariff Act and the Sterling Exchange Rate. These policies reduced international trade, causing a contraction in demand for goods and services around the world.
  3. The Oil Crisis (1973-1974): This period of de-globalization was caused by the OPEC oil embargo, which dramatically increased the price of oil and led to a global recession. This caused an increase in inflation and decreased consumer spending, leading to a decrease in global trade and growth.
  4. The Cold War: The Cold War led to a further decrease in global trade and investment flows, as countries adopted protectionist policies to protect their markets from foreign competition. This caused a decrease in economic growth throughout the world as countries struggled to adjust to the new economic environment.

Impact of de-globalization on the stock market

Globalization has had a significant positive impact on the stock market. It has increased market efficiency and liquidity, enabled more efficient capital allocation, and improved access to international markets. The increased liquidity has led to a generally smooth climb in the overall stock market indices. This has allowed investors to diversify their portfolios by taking advantage of opportunities in different regions, leading to higher returns.

The de-globalization of the stock market could potentially have the opposite effect. An increase in protectionism and the resulting trade disruptions could reduce liquidity, decrease market efficiency, and limit access to international markets. This could lead to lower returns, and increased volatility.

Active Investing

Advantages of active investing

Active investing may outperform passive investing when markets are volatile and when there are opportunities for arbitrage. Additionally, if an investor has a strong understanding of the markets and is able to identify long-term opportunities, then active investing may provide better returns than passive investing.

Disadvantages of active investing

  1. High Cost: Active investing can be very expensive as it involves frequent trading, resulting in higher brokerage fees, bid-ask spreads, and taxes.
  2. Time-Consuming: It requires a lot of time and research to monitor the markets and identify the best opportunities for investment.
  3. Poor Performance: Despite the best efforts of active investors, there is no guarantee that their investments will outperform the market.
  4. High Risk: Active investing involves a higher level of risk as there is less diversification.

Passive Investing

Advantages of passive investing

Advantages of passive investing:

  1. Lower costs: Passive investors do not have to pay the high fees associated with active management, this can result in more money to invest and higher returns over time, provided that what they buy isn’t overvalued, and they hold long enough.
  2. Simplicity: Passive investors can save time and money by not having to research and monitor their investments.
  3. Diversification: Passive investors can spread their money across different asset classes, reducing the risk of their portfolio.
  4. Tax efficiency: Passive investments are more tax efficient than active investments, as they tend to have fewer transactions and can take advantage of certain tax-advantaged accounts, such as individual retirement accounts (IRAs) and 401(k)s.

Disadvantages of passive investing

  1. Limited opportunity to capitalize on market inefficiencies: Passive investors typically cannot take advantage of market inefficiencies, since they are not actively making decisions about their investments.
  2. Lower potential for higher returns: The lack of active management means that passive investments may have lower potential for higher returns compared to actively managed investments.
  3. Lack of customization: Passive investments are often limited to a predetermined portfolio, with no ability to customize the holdings.
  4. Potential for increased risk: Without active management, passive investors may be exposed to increased risk in the markets.

Comparison of Active and Passive Investing

Active investing refers to the practice of making investment decisions based on an investor’s own research and analysis. This typically involves making individual stock, bond, or other security selections, and actively managing portfolios.

Passive investing is an investing strategy that seeks to maximize returns by minimizing trading activity and avoiding attempts to time the market. It relies on the notion that markets are efficient, and that all available information is already reflected in the price of an asset. Passive investing typically involves investing in a broad index fund or exchange-traded fund (ETF) that tracks a given index, such as the S&P 500.

The main difference between active and passive investing is the amount of effort and research required. Active investing requires more effort and research, while passive investing requires very little effort and research. Active investors aim to outperform the market, while passive investors seek to match the performance of the market. Additionally, active investors often trade more frequently, while passive investors may only trade occasionally.

Comparison of returns

Let’s use the Castle Tandem Fund (TANDX) as an example of an actively managed mutual fund. According to the prospectus:

..the fund invests primarily in common stocks of large-capitalization companies.

So we’ll use the S&P 500 as our comparison.

As you can see in the charts below, the TANDX fund beat the S&P 500 index over the 2022-2023 period:

TANDX_1yr

However, the fund trailed the index over the 5 year period prior.

TANDX_5yr

The takeaway: Actively managed funds can beat their index over short periods, where the investment style is right for the time.

Comparison of risk

Active Investing Risks:

  • Higher cost due to fees charged by active managers
  • Risk of under-performance of the market or other passive strategies
  • Timing risk, which is the risk of selling or buying too soon or too late

Passive Investing Risks:

  • Higher risks of momentum investing, such as buying into a bubble and selling too late
  • Long-term under-performance due to the lack of reactivity to changing market conditions
  • Higher risk of tracking error, meaning the gap between the performance of the fund and the underlying index

Conclusion

In conclusion, it’s clear that both active and passive investing can be powerful and successful approaches to managing your investments, each with their own merits and drawbacks. However, when markets are volatile and uncertain, active investing may be the better choice. As an investor, it’s important to understand the differences between these two strategies in order to make the best decision for your own financial well-being.

My name is Michael. My background is in technology, not finance.

What this means is that my head isn’t filled with high-flying, new-economy financial theory nonsense that universities pump out these days to justify the absurdity of wall street.


What I lack in letters following my name I make up for in experience. 20 years of active investing experience – counting 3 (as of March, 2020) bubbles and subsequent busts, to be exact.


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