What is Passive Income Investing (Does it Work?)
February 27, 2023
Passive Income Investing in Canada
Passive income investing is an interesting concept, and the debate surrounding the strategy will likely become more sharply focused over the next few years, particularly in Canada.
Over 30 years ago, after previously working with professional institutional investors as an order taker in practice, I moved over and began working with individual retail investors such as yourself as an advisor, and I was not very impressed with the average stockbroker or investment advisor. It seemed like the “wild west” to me, not unlike the movie “The Wolf of Wall Street.” Clients were being sold stocks based upon very little research, often based on commission rates or new issue commissions. And clients had very little information on the rate of return they were achieving, and almost zero information on how much risk they were taking through their broker.
I was looking for a new way forward, a more structured and professional process to manage my clients’ portfolios. This eventually led me back to my institutional roots, and we began employing a very sophisticated Nobel Prize-winning mathematical process, used by virtually all significant institutional investors, and based upon modern portfolio theory – to build and manage client portfolios. We still use this process today, and the long-term track of performance success of our model portfolios is self-evident.
The History of Passive Income Investing in Canada
One of the basic building blocks of those portfolios was created in the 1990s, when the first exchange-traded fund in North America called TIPs was created, which stood for Toronto 35 Index Participation Units. It was one stock which was available to buy on the equity market like any other stock, and it tracked the Toronto Stock Exchange’s top 35 stocks. Surprisingly, the first successful passive investment vehicle was created in Canada, a relatively small fish compared to larger equity markets such as America and Asia.
TIPs was met with huge resistance from the investment industry on both Bay Street in Canada and Wall Street in the U.S. because it threatened many parts of the industry, particularly their revenue streams. At the time, Mutual funds were the preferred commercially available portfolios. I, however, loved it. TIPs was soon followed by a similar exchange-traded fund in the U.S. for the S&P 500 called SPDR, which I also loved. And so began the very first truly passive index investment vehicles.
What is Passive Income Investing
ETFs are called passive because, with one security, you can gain exposure to an entire market with a very low to no management fee. And on the issue of cost, keep in mind that truly passive investment vehicles like these have no manager, and there are no investment decisions made. That is what mutual funds are for. Exchange-traded funds, simply via computer, own the entirety of the market in the correct percentage based upon the market capitalization of each underlying stock. So, the cost is as close to zero as you are going to get. Owning these core ETFs is also called “Index Investing.”
As ETFs became more popular, more funds emerged to track smaller indices such as growth or value indexes. Then they further stratified into industry types, such as technology, energy, housing etc. As they did this, ETFs began to “eat the lunch” or take away the market share of Mutual Fund companies – and with good reason; studies have shown that mutual funds, on average, underperform the index funds over 80% of the time, after fees. Who wants to pay heavy fees, only to underperform the broad market index 80% of the time?
|Active Investing||Passive Investing|
|Attempting to “beat the market”||Only trying to achieve market return|
|Expenses are higher due to management costs||Automatic asset allocation incurs negligent costs|
|Trading frequency may incur higher taxes||May be more tax efficient|
Alpha is related to beta – but refers to the rate of return achieved by an investment over and above the market beta. For instance, if the market beta for a particular time frame was 7%, and a particular investment returned 9% over that same time frame, then this investment would have an alpha of +2.
What will become increasingly important in this new era we are likely entering, will be building portfolios which can generate alpha. And again, this is simply because market beta will likely not drive satisfactory returns in the next economic era as it had in the past.
Passive Income Investing and Market Beta
To understand passive investing completely, one must first understand an important concept in investing called market beta. Market beta is effectively the performance and risk profile of the overall marketplace. For instance, the market beta for the U.S. equity market is the S&P 500 index. In Canada, the market beta would be the return and risk profile of the S&P TSX Index.
Core ETFs allow investors the ability to gain exposure to Market Beta very simply and inexpensively. Keep in mind that passive or index investors are not trying to beat the market; they are simply seeking to achieve the market rate of return or Market Beta. Over the past 15 years, this has been a very effective strategy. Since the financial crisis of 2008, central banks have pumped cash into the economy and financial markets while lowering interest rates.
This is called an “easy money” policy, and it has worked to drive up the value of equity markets as a whole, therefore significantly driving up the return that Market Beta was delivering, which of course, has handsomely rewarded passive or index investors.
And because it has been profitable, passive index investing has become ever more popular in recent years. But will this work over the next several years?
Does Passive Income Investing Still Work?
This economy is rapidly transforming. As I have discussed in extensive videos on this topic, what has worked over the past 15 years likely will not over the next foreseeable number of years. Inflation has taken hold, government debt levels are now unsustainable, and the economy is rapidly decelerating. We are in for an entirely different economic weather pattern. To provide some context: since January 1st of 2022, the major market indexes are down from 10% to 33%. So, it has been an absolutely horrible year for passive Market Beta index investors. More troubling, the necessary and fundamental economic shifts which have caused this poor year, will likely endure.
In the recent words of Wall Street legend Stanley Druckenmiller, one of the most successful hedge fund managers of all time who rarely gives interviews: “I don’t expect that the Dow will be much higher in 10 years than it is right now”. Time will tell if he is right or not, and a decade is a long time to look into the future. But, if Druckenmiller is right, and we are at the end of an era of Central Banks printing money and pushing it into the economy, then passive index investing will be far less profitable in the future, than it has been in the past.
How We Use ETFs
At McIver Capital Management, we use very specific targeted ETF’s to cover parts of the market more effectively covered by a more broad approach. But we own them in an active manner, meaning we shift our holdings of these ETFs. Additionally, this is only one part of our approach in our client portfolios, and most positions are individual stock and bond positions.
We also use a regular rebalancing technique to take advantage of both market normalization and seasonality. Each of these processes is designed to generate alpha.
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