Here Comes the Bus: The Problem with Passive Investing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 29, 2017 2:22:23 PM

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passive investingYesterday, we talked about the worries surrounding exchange-traded funds (ETFs)—chiefly, that they could trigger a flash crash. Ultimately, we concluded that ETFs are just an enabling technology, not the real problem. The real problem, at least potentially, is passive investing. Let’s take a closer look at what the passive investing trend could mean for the markets.

The problem with good ideas

A problem often emerges when an otherwise good idea is taken to extremes. From an individual investor perspective, passive investing is a great idea. When you buy a fund that mirrors an index—say, the S&P 500—you get exposure to the economy as a whole, at a very low cost, and without a lot of work. At the individual level, passive investing has been a successful approach for decades, initially through mutual funds and now through ETFs. The arguments behind it continue to be compelling.

But, as Mom used to say, would you like it if everyone did it? What works at the individual level often causes problems at the system level. We see this in economics, where individual savings is good, but if everyone saves, the economy slows. Passive investing, if everyone does it, can have similar unfortunate side effects for the markets as a whole.

The problem with price setting

The point of markets is to set prices. Individual companies should, and historically have, traded on their own performance. Stock pickers could identify and purchase underpriced stocks, driving prices up, while overpriced shares were free to drop as the companies disappointed investors. The point here is that buyers were looking at companies and setting prices based on the value they saw. At the company level, there’s a metric for success or failure, and investors can react accordingly.

With passive investing, however, there is no real metric for setting those company prices. When you buy a fund that mirrors an index, you buy all of the companies in the index at whatever their price is today. Since there is no price discovery at the company level, the prices of the companies—and of the index—can keep going up indefinitely.

This is where active investors serve a valuable purpose—by trading against companies that are valued too highly and by keeping them and the index connected to reality. Historically, this is exactly what has happened, and passive investors have been able to keep buying funds tracking an index with reasonable valuations.

What happens, though, when the active investors go away? Or, more realistically, what happens when the passive investors throw in so much cash that it overwhelms active investors’ ability to keep prices in line with reality? When the bus is traveling that quickly, they simply can’t react fast enough.

The problem with fund flows

Arguably, this is where we are right now. Fund flows into passive vehicles, including ETFs, are so large that the indiscriminate buying of stocks is overwhelming more price-sensitive investors. This has been going on for some time, and it’s likely to continue, at least for a while. What happens, though, when the fund flows stop?

Looking at history, we can see that investor enthusiasm can drive markets to high levels (for two recent examples, think technology and housing). But when the enthusiasm wanes, so do the gains. Passive investing, which has driven all of the shares in the most popular indices, may well end up in the same place.

What can investors do? Passive investments certainly have a place in a portfolio, but so do active managers—who can more effectively position themselves for when the markets change course. Even among passive investments, there are options available that avoid investing in the most highly valued stocks. As always, strategy diversification is every bit as important as asset class diversification.

Passive investing remains a valuable tool, but it’s not the only tool. Recognize the advantages, but also plan for the risks. Now is the time to start thinking about what happens when the bus comes barreling through the intersection.

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