Disclaimer: This article is not personal finance advice, it is simply my contrarian opinion to a worrying trend I see in the financial markets. If I can highlight risks people are ignoring and thereby save someone from losing their retirement savings I will be happy.
Passive investing is becoming one of the most popular investment strategies for the average American. Professional investors such as Jack Bogle and Warren Buffet recommend passively investing in index funds. The benefits of low-cost index funds are frequently discussed by financial journalists and pundits. The benefits of passive investing are talked about so much it’s often hard to find anyone discussing the dangers it poses to individuals and the economy at large. Cynics often rudely dismiss anyone espousing the benefits of active management as an active manager trying to recruit new investors.
Every year, passive investing’s share of assets under management in U.S. funds is increasing. By year end 2017, passive investments accounted for nearly 45 percent of all equity assets in U.S. mutual funds and exchange-traded products. (source) The risks that passive investing poses to individual investors and the economy are not isolated to a small part of the economy, this investment type has created systematic risks. I will discuss these risks to the individual investor and the entire economy.
Appearance as a low-risk investment
Passive investing, particularly in the form of Exchange-traded funds (ETFs) is advertised as an investment strategy that provides consistent returns, safety, and liquidity at a lower cost than active managed funds. The main reason passive investing is seen as a good investment strategy is because they cost less and have outperformed most active managers since the Great Recession ended in 2009.
As of March 2019, the Dow Jones Industrial Average (Dow) has had annual returns of 13.92% over the ten-year period since March 2009. If you had invested $1000 in the Dow in March 2009 you would have had $3680 in March 2019.
That’s a return on investment that no one can argue with. If someone offered me that return over the next 10 years I would take it immediately.
The issue is that people have fallen into the trap of recency bias, and many people invest while “looking in the rear view mirror”. It’s part of investor psychology fall into this trap, they see a lot of money that was made with an investment strategy and decide to adopt it. They forget that past performance is not guarantee of future results. Every hot investment style looks great when you look in the rear view mirror, just look at how many people invested in Bitcoin without understanding it.
Investors forget what it’s like when stocks aren’t rising. From high to low in 2009, during the Great Recession, the Dow Jones Industrial Average fell 50%. If someone had invested their life savings in an ETF right before the Great Recession they would have lost half of their money.
Passive investing causes market distortion
The shift in market structure from almost entirely individual stock picking and active management to a large amount of passive investing has had a profound change on the stock market. Passive investing is rules-based investing, not fundamentals based investing. ETFs that track stock indices have to buy more equities that rise in price which leads to those stocks rising further in price.
This leads to funds buying more of the expensive stocks in an index and less of the cheap ones. This phenomena involves firms practicing the unconventional investment strategy of “buy high, sell low”, which most people will understand is a bad strategy. Since there is no regard for prices or fundamentals there is a risk of a bubble forming with high priced equities. A market correction of these overbought equities could lead to them being disproportionally sold if the market returned to a price based on underlying value and fundamentals.
ETFs and index funds are not structured to actually invest based on underlying business fundamentals. If everyone in an economy was a passive investor there would be incredibly inefficient allocation of capital. There would be no mechanism for valuing companies based on their business fundamentals such as cash flow and net margins, so there would be no way to accurately gauge the value of any security.
The misallocation of capital as a result of passive investing causes a risk for the entire economy. If more regular Americans are passively investing in index funds, that means there is capital that is being invested in well managed companies with solid fundamentals. That means these businesses have less opportunity to grow. Instead the money is chasing whichever stocks have the benefit of being in an index because they are older, larger, and more established.
This isn’t just my speculation and fear mongering about the dangers of passive investing. In their academic study appropriately titled “Is there a Dark Side to Exchange Traded Funds? An Information Perspective,”
“We examine whether an increase in ETF ownership is accompanied by a decline in pricing efficiency for the underlying component securities. Our tests show an increase in ETF ownership is associated with (1) higher trading costs (bid-ask spreads and market liquidity), (2) an increase in “stock return synchronicity,” (3) a decline in “future earnings response coefficients,” and (4) a decline in the number of analysts covering the firm. Collectively, our findings support the view that increased ETF ownership can lead to higher trading costs and lower benefits from information acquisition. This combination results in less informative security prices for the underlying firms.”
Not only does an increase in ETF ownership make the financial markets more inefficient, it also means there is less information about securities because there is a decrease in the number of “sell-side” analysts and less investment research. This is a frightening trend for people that believe in the efficiency of financial markets. With less research and investment based on fundamentals, markets become less efficient.
Passive investing causes liquidity issues
Israeli et al. also discovered that an increase in ETF ownership is associated with higher trading costs and lower liquidity. In a financial crisis with a higher proportion of ETFs there will be an even greater shortage of liquidity. But an even bigger issue, how will the ETF fund managers find liquidity in a crisis? Investment dealers (usually banks) are the market makers for ETFs. When the stock price of an ETF falls below the value of the assets underlying it (NAV) banks will step in and buy the ETF shares at a discount and sell them later at a premium. This market making role is one that banks have no issue providing in ordinary market conditions, but will they still provide this service when the market is crashing?
Passive investing leads to more income inequality
This happens through the increased risk of poor corporate governance that happens with index funds. Since index funds own every individual stock in an index they are less likely to get involved with corporate governance. Contrast this with an actively managed fund such as a hedge fund that often use the voting power of their shares to vote on the board of directors or the CEO of a company. The passive corporate governance is a particular issue when dealing with the pay packages for executives.
In their academic study titled “Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy” Lucian Bebchuk and
Scott Hirst address the effect of index funds on corporate governance. I quote from the abstract (emphasis mine):
Index funds own an increasingly large proportion of American public companies, currently more than one fifth and steadily growing. The stewardship decisions of index fund managers—how they monitor, vote, and engage with their portfolio companies—can be expected to have a profound impact on the governance and performance of public companies and the economy. Our agency-costs analysis shows that index funds have strong incentives to (i) under-invest in stewardship, and (ii) defer excessively to the preferences and positions of corporate managers.
Put simply, there is no incentive for passive fund managers to engage in serious stewardship. This leads to these fund managers deferring excessively to the preferences of corporate mangers. This leads to higher pay packages for executives. Index funds use their proxy voting power to approve of pay packages for executives 19% more frequently than active funds. Yes, passive investing is contributing to greater executive pay packages because of lackadaisical ownership of voting shares. This seemingly blind support for corporate management will lead to bad decisions by managers because there are less shareholders that want to hold them accountable.
Passive index investing has shown itself to be the right investment strategy for the last 10 years. This proves that index funds, ETFs and passive investing have merit and provide value as a niche financial product. The issue is that they are a form of “blind money” investing, that is not based on any underlying investment principles or fundamentals. The next recession will provide a major test for this relatively young ETF market. If you have a large amount of your net worth in passive index investments I highly recommend you consider diversifying your investment strategy or employ hedging techniques.