Losing money with passive investing

Losing money with passive investing

18-10-2017 | Column
Passive investing may be popular, but it also raises serious concerns. In particular, it means getting exposure to stocks that not only don't add to performance, but actually have a negative impact on it.
  • David Blitz
    Chief Researcher

Speed read:

  • Passive investing means assuming the CAPM works
  • But the CAPM has a very poor empirical track record
  • A better approach to is use a multi-factor ranking model

A century of empirical evidence shows that although equities exhibit high volatility in the short run, they are rewarded with a higher return than bonds and cash in the long run. In order to capture this so-called equity premium, many investors have an allocation to equities in their strategic asset mix.

An increasingly popular way to earn the equity premium in practice is by replicating a broad capitalization-weighted equity market index which serves as a good proxy for the theoretical equity market portfolio. Such a passive investment approach allows investors to earn the equity premium at a minimal cost. It also takes into account that more expensive actively managed funds have failed to outperform as a whole, although that is not surprising given that active investing is a zero-sum game before costs, and a negative-sum game after costs.

Passive investing boils down to investing a little bit each in thousands of individual stocks. These thousands of investments combined should earn investors the equity premium. But does each of these individual stocks really help you capture the overall equity premium? The answer could be yes if the expected return premium for every stock were the same and equal to the overall equity premium. 

In that case, however, investors would be better off investing in a minimum volatility portfolio, as that would allow them to earn this expected return premium with the least risk. The literature on minimum volatility strategies shows that it is not very difficult to create a portfolio which is less risky than a broad capitalization-weighted market index. Clearly, therefore, passive investing in a broad market index is not a logical course of action if one expects every stock to have the same expected return.

So which assumption would justify passive investing in a broad capitalization-weighted market index? The above implies that at the very least, one must assume that certain stocks have higher expected returns than others. More specifically, if one assumes that the Capital Asset Pricing Model (CAPM) holds, it can be shown that the market portfolio is, in fact, the optimal choice for investors. The CAPM postulates that the expected return on a stock is proportional to its level of systematic risk, or beta. In other words, a stock that is half as risky as the equity market portfolio should earn only half the equity premium, while a stock that is twice as risky as the equity market portfolio should earn double the equity premium.

Passive investing means assuming that the CAPM works, but is that a reasonable assumption?

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates

Passive investing means assuming the CAPM works

So passive investing according to a broad capitalization-weighted index is justified, assuming that the CAPM works, but is that a reasonable assumption? Based on the popularity of the CAPM in standard finance textbooks, one might be inclined to think that it is. Empirically, however, the model has a very poor track record. Studies which have tested the predictions of the CAPM using real data have failed to find a positive relationship between systematic risk and stock returns. The actual relationship appears to be flat, or even inverted, i.e., if anything, riskier stocks tend to generate lower rather than higher returns. 

Whereas systematic risk turns out to be a poor predictor of future expected stock returns, various other stock characteristics, such as the size, valuation, momentum and quality features of a stock, have been found to be powerful indicators of future expected returns. Models which include a combination of such factors have effectively replaced the theoretically elegant but empirically disappointing CAPM. Examples of such models are the three-, four-, and five-factor models of renowned professors Fama and French, and others.

What do these widely known insights imply for the expected return of individual stocks? In order to answer this question, we created a simple model, inspired by the literature on which characteristics drive stock returns. Specifically, we ranked stocks, dividing them into five groups every month, based on their total score in terms of a combination of commonly used value, momentum, quality, and low volatility factors. Next, we looked at the performance of these five portfolios from 1986 to 2016, which is the longest period for which we have data on global stocks. The figure below shows that our simple model is highly effective at separating stocks with high average returns from those with low expected returns.

Particularly interesting is the finding that the 20% of the stocks with the least attractive factor characteristics generated a negative premium over period of more than thirty years, amounting to minus 2.5% per annum versus cash, and even minus 4% per annum versus high-grade government bonds. If all stocks earned a positive premium at the very least, one might still shrug off the whole discussion about factor characteristics by arguing that although some stocks may have lower returns than they ought to, they do at least still contribute positively to performance. 

These results, however, show that a significant portion of a passive portfolio is actually invested in stocks which contribute negatively to performance. Next time you hear someone arguing that passive investing is a prudent approach, think twice about that. And bear in mind that the model which we used here to rank stocks is still quite simple. Quant asset managers such as Robeco have developed more sophisticated models which show an even bigger return spread between attractive and unattractive stocks.

Source: Robeco
What is the intuition about these results? Well, taken together, stocks may earn a healthy premium, but that does not mean that every stock individually can be assumed to do so. In particular, if a stock is expensive based on straightforward valuation multiples such as P/E, is in a downtrend, has low profitability, and is also very risky, then decades of historical data tell us that such a stock should not be expected to deliver a positive, but rather a negative premium. Passive investors, however, choose to ignore this evidence, and happily invest in stocks with such a deadly cocktail of characteristics just as they do in any other stock.

Passive investing leads to inefficient portfolios

Proponents of passive investing might counter that they are neither believers nor disbelievers in factor premiums. If all you can be reasonably sure about is that there is a long-term equity premium and you are agnostic about the existence of factor premiums, isn’t passive investing a sound approach? The problem with this argument is that the investment choices one makes point to certain implicit views, or ‘revealed preferences’ as economists call them. 

Investing passively in the capitalization-weighted index means that one implicitly assumes that a model such as the CAPM holds, and that the factor premiums which have been observed in historical data are either not exploitable in real life, or will no longer materialize in the future, e.g. because they were a mere historical fluke or have by now been arbitraged away. Clinging to a theoretical construct from the 1960s and simply dismissing everything we have come to know about stock returns since then is not prudent, but seems more like wishful thinking, an intentionally contrarian strategy, or denial of inconvenient facts.

So, passive investing means putting a significant chunk of the portfolio in stocks which have a negative expected premium, i.e. which not only do not add to performance but actually have a negative impact on it. But what are the investment implications of this insight? In other words, if investors do not want to suffer passively due to stocks that only cost them money, what can they do instead? One alternative would be to invest passively in all stocks, except, for instance, the 20% of stocks with the least attractive factor characteristics. 

That is not as easy as it sounds though, because factor characteristics of stocks are not constant but are continuously evolving. This means that the 20% of stocks that are least attractive this month will be different from next month’s 20%. Since factor characteristics do not change drastically overnight, one does not need to completely reconstitute the portfolio all the time, but still, active maintenance is required, and this involves some periodic turnover.

A more efficient approach is to not only avoid the least attractive stocks according to a multi-factor ranking model, but to also invest the proceeds in the most attractive stocks according to the model. These stocks not only exhibit the highest expected return based on their factor characteristics, but are also the ones that are least likely to drop down to the worst category in the near future, which helps to save turnover. Our enhanced index and factor index strategies are based on such principles, and are specifically designed to avoid the pitfalls of passive index strategies. For more information on our efficient alternatives to passive investing, please contact your local Robeco client relationship manager.

Important information

The contents of this document have not been reviewed by the Securities and Futures Commission ("SFC") in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. This document has been distributed by Robeco Hong Kong Limited (‘Robeco’). Robeco is regulated by the SFC in Hong Kong.
This document has been prepared on a confidential basis solely for the recipient and is for information purposes only. Any reproduction or distribution of this documentation, in whole or in part, or the disclosure of its contents, without the prior written consent of Robeco, is prohibited. By accepting this documentation, the recipient agrees to the foregoing
This document is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. Investment decisions should only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. Please refer to the relevant offering documents for details including the risk factors before making any investment decisions.
The contents of this document are based upon sources of information believed to be reliable. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation.
Investment Involves risks. Historical returns are provided for illustrative purposes only and do not necessarily reflect Robeco’s expectations for the future. The value of your investments may fluctuate. Past performance is no indication of current or future performance.



1. General
Please read this information carefully.

This website is prepared and issued by Robeco Hong Kong Limited ("Robeco"), which is a corporation licensed by the Securities and Futures Commission in Hong Kong to engage in Type 1 (dealing in securities); Type 4 (advising in securities) and Type 9 (asset management) regulated activities. The Company does not hold client assets and is subject to the licensing condition that it shall seek the SFC’s prior approval before extending services at retail level. This website has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.

2. Important risk disclosures
2. Important risk disclosures Robeco Capital Growth Funds (“the Funds”) are distinguished by their respective specific investment policies or any other specific features. Please read carefully for the risks of the Funds:

  • Some Funds are subject to investment, market, equities, liquidity, counterparty, securities lending and foreign currency risk and risk associated with investments in small and/or mid-capped companies.
  • Some Funds are subject to the risks of investing in emerging markets which include political, economic, legal, regulatory, market, settlement, execution, counterparty and currency risks.
  • Some Funds may invest in China A shares directly through the Qualified Foreign Institutional Investor (“QFII”) scheme and / or RMB Qualified Foreign Institutional Investor (“RQFII”) scheme and / or Stock Connect programmes which may entail additional clearing and settlement, regulatory, operational, counterparty and liquidity risk.
  • For distributing share classes, some Funds may pay out dividend distributions out of capital. Where distributions are paid out of capital, this amounts to a return or withdrawal of part of your original investment or capital gains attributable to that and may result in an immediate decrease in the net asset value of shares.
  • Some Funds’ investments maybe concentrated in one region / one country / one sector / around one theme and therefore the value of the Fund may be more volatile and may be subject to concentration risk.
  • The risk exists that the quantitative techniques used by some Funds may not work and the Funds’ value may be adversely affected.
  • In addition to investment, market, liquidity, counterparty, securities lending, (reverse) repurchase agreements and foreign currency risk, some Funds are subject to risk associated with fixed income investments like credit risk, interest rate risk, convertible bonds risk, ABS risk and the risk of investments in non-investment grade or unrated securities and the risk of investments made in non-investment grade sovereign securities.
  • Some Funds can use derivatives extensively. Robeco Global Consumer Trends Equities can use derivatives for hedging and efficient portfolio management. Derivatives exposure may involve higher counterparty, liquidity and valuation risks. In adverse situations, the Funds may suffer significant losses (even a total loss of the Funds’ assets) from its derivative usage.
  • Robeco European High Yield Bonds is subject to Eurozone risk.
  • Investors may suffer substantial losses of their investments in the Funds. Investor should not invest in the Funds solely based on the information provided in this document and should read the offering documents (including potential risks involved) for details.

3. Local legal and sales restrictions
The Website is to be accessed by “professional investors” only (as defined in the Securities and Futures Ordinance (Cap.571) and/or the Securities and Futures (Professional Investors) Rules (Cap.571D) under the laws of Hong Kong). The Website is not directed at any person in any jurisdiction where (by reason of that person’s nationality, residence or otherwise) the publication or availability of the Website is prohibited. Persons in respect of whom such prohibitions apply or persons other than those specified above must not access this Website. Persons accessing the Website need to be aware that they are responsible themselves for the compliance with all local rules and regulations. By accessing this Website and any of its pages, you acknowledge your agreement with understanding of the following terms of use and legal information. If you do not agree to the terms and conditions below, do not access this Website or any pages thereof.

The information contained in the Website is being provided for information purposes.

Neither information nor any opinion expressed on the Website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. The information contained in the Website does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. An investment in a Robeco product should only be made after reading the related legal documents such as management regulations, prospectuses, most recent annual and semi-annual reports, which can be all be obtained free of charge at www.robeco.com/hk/en and at the Robeco Hong Kong office.

4. Use of the Website
The information is based on certain assumptions, information and conditions applicable at a certain time and may be subject to change at any time without notice. Robeco aims to provide accurate, complete and up-to-date information, obtained from sources of information believed to be reliable. Persons accessing the Website are responsible for their choice and use of the information.

5. Investment performance
No assurance can be given that the investment objective of any investment products will be achieved. No representation or promise as to the performance of any investment products or the return on an investment is made. The value of your investments may fluctuate. The value of the assets of Robeco investment products may also fluctuate as a result of the investment policy and/or the developments on the financial markets. Results obtained in the past are no guarantee for the future. Past performance, projection, or forecast included in this Website should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Fund performance figures are based on the month-end trading prices and are calculated on a total return basis with dividends reinvested. Return figures versus the benchmark show the investment management result before management and/or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark.
Investments involve risks. Past performance is not a guide to future performance. Potential investors should read the terms and conditions contained in the relevant offering documents and in particular the investment policies and the risk factors before any investment decision is made. Investors should ensure they fully understand the risks associated with the fund and should also consider their own investment objective and risk tolerance level. Investors are reminded that the value and income (if any) from shares of the fund may be volatile and could change substantially within a short period of time, and investors may not get back the amount they have invested in the fund. If in doubt, please seek independent financial and professional advice.

6. Third party websites
This website includes material from third parties or links to websites maintained by third parties some of which is supplied by companies that are not affiliated to Robeco. Following links to any other off-site pages or websites of third parties shall be at the own risk of the person following such link. Robeco has not reviewed any of the websites linked to or referred to by the Website and does not endorse or accept any responsibility for their content nor the products, services or other items offered through them. Robeco shall have no liability for any losses or damages arising from the use of or reliance on the information contained on websites of third parties, including, without limitation, any loss of profit or any other direct or indirect damage. Third party off-site pages or websites are provided for informational purposes only.

7. Limitation of liability
Robeco as well as (possible) other suppliers of information to the Website accept no responsibility for the contents of the Website or the information or recommendations contained herein, which moreover may be changed without notice.
Robeco assumes no responsibility for ensuring, and makes no warranty, that the functioning of the Website will be uninterrupted or error-free. Robeco assumes no responsibility for the consequences of e-mail messages regarding a Robeco (transaction) service, which either cannot be received or sent, are damaged, received or sent incorrectly, or not received or sent on time.
Neither will Robeco be liable for any loss or damage that may result from access to and use of the Website.

8. Intellectual property
All copyrights, patents, intellectual and other property, and licenses regarding the information on the Website are held and obtained by Robeco. These rights will not be passed to persons accessing this information.

9. Privacy
Robeco guarantees that the data of persons accessing the Website will be treated confidentially in accordance with prevailing data protection regulations. Such data will not be made available to third parties without the approval of the persons accessing the Website, unless Robeco is legally obliged to do so. Please find more details in our Privacy and Cookie Policy.

10. Applicable law
The Website shall be governed by and construed in accordance with the laws of Hong Kong. All disputes arising out of or in connection with the Website shall be submitted to the exclusive jurisdiction of the courts of Hong Kong. 

Please click the “I agree” button if you have read and understood this page and agree to the Disclaimers above and the collection and use of your personal data by Robeco, for the purposes for which such data is collected and used as set out in the Privacy and Cookie Policy, including for the purpose of direct marketing of Robeco products or services. Otherwise, please click “I Disagree” to leave the website.

I Disagree