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Are There Potential Downfalls to Passive Investing?

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A recent article from the LA Times highlighted the recent trend of small investors putting more of their retirement savings into passive index funds. Citing multiple statistics from the Investment Company Institute, the rise of passive investing is starting to sweep the nation. Some of these statistics include:

  • $1.46 trillion dollars in net outflows from actively managed U.S. stock mutual funds between 2005 and 2016.

 

  • 42% of all U.S. stock assets are now held in passively managed index funds or exchange traded funds, up from 11.9% in 2000.

 

  • The percentage of actively managed funds that have beaten their index over the last 15 years is quite low across most asset classes.

With all of this positive news about passive investing, you would imagine that there might be some skeptics. In fact, some have suggested that passive investors could be inherently working against themselves in the long run. The LA Times article goes on to list potential pitfalls of passive investing that are on the rise. We are going to address these one-by-one.

Passive investing makes the market less efficient – meaning, less honest

In theory, this is true. If we take the argument to the extreme example where everyone used index funds, there would be nobody participating in the price discovery process that is necessary for security valuation. In other words, we need active participants in order to take information and imbed it into prices so that securities are fairly valued based on fundamentals and future expectations. This process is what generates our fair return for risk taken by investors.

But as the article highlights by quoting Research Affiliates founder, Rob Arnott, to suggest that the U.S. market has become less efficient given the recent rise in passive investing seems very premature. In their own words, “the U.S. stock market is worth $26 trillion, but only about 25% of that is owned by passive funds.” Simply put, we are still very far from being concerned about markets being less efficient.

Another tell tale sign that markets haven’t become less efficient is the continued underperformance by the majority of active fund managers. If the alternative is to all of a sudden reverse course and try to actively beat the market, there is no evidence that this strategy is likely to be a winning a proposition.

Passive investing inflates already-hot market sectors

Let’s unpack this comment a little bit. In order to define a sector as “hot” or “cold” is to believe that there is a trend or misevaluation being made by the market. If the health care sector has enjoyed recent outperformance relative to other sectors of the economy, it could be due to the future prospects for growth that market participants are anticipating, not because the market is all of a sudden not working properly.

Nonetheless, to say passive investors are contributing to the inflation of market prices versus fundamentals is to suggest that active market participants are asleep at the wheel. If passive investors are possibly pushing up prices relative to fundamentals, then active investors will sell portions of their positions in order for prices to more accurately reflect fundamentals. It is a constant give and take between passive and active participants in which equilibrium is approximately maintained.

The LA Times article also mentions Research Affiliates’ (RAFI) method of fundamental indexing as a way to control this possible inflation in prices. We have written articles before about the pitfalls of fundamental indexing here, which is based on the idea of “The Noisy Market Hypothesis (NMH).” In a nutshell, the NMH is not logically sound and breaking the link between prices and fundamentals is not necessarily a profitable strategy. In fact, there is no reliable difference in performance between RAFI ETFs and passive strategies that do rely on market prices like the ones offered by Dimensional Fund Advisors.

The last point this article makes about this particular pitfall is that investment companies, like Dimensional, that take a multi-factor approach to building their strategies are not “pure” forms of indexing since they tilt away from larger, more growth-oriented companies towards smaller, more value-oriented companies in attempts to beat the market. It is important to know that the “market” is multi-dimensional in the sense of how risk is being priced. While it may be simple to think in terms of one metric such as market capitalization, it would be analogous to looking solely at the engine of a car and not understanding its underlying components. By understanding the drivers of risk and return, you can index the market by multiple metrics that are attempting to capture risk premiums that we are expected to be compensated for with additional return. Not all indexing is created equal so to say what is “pure” is completely arbitrary. We have written before about Dimensional’s approach and why they are our preferred fund partner.

Passive investing could be a bubble that will eventually pop

As the word “could” insinuates, on its face this statement is pure speculation. The arithmetic of active investing will never change. Net of costs, a passive investor will always outperform the average active investor. While some have attributed the recent rise in passive investing to the bull market we have experienced since 2009, we would argue that more and more people are starting to pay attention to the facts.

The argument that is made for why indexing cannot do well over the long term is that investors cannot stick with it through thick and thin. This isn’t an indexing issue. This is a behavioral issue, which we believe can be remedied with fiduciary wealth managers who act as allies for their investors. IFA’s entire business model is built on a foundation of educating investors and arming them with information they need to weather any market downturn.

Is active management the solution to market downturns? Of course not! Just like active managers struggle to consistently time the upside of the market, they also struggle with protecting investors from the downside. We have already written articles before on the topic of active management providing protection during down markets here. We referenced a paper from the Fall 2012 edition of the Journal of Investing called Modern Fool’s Gold: Alpha in Recessions, which concluded that there is very weak persistence in a manager’s ability to provide superior outperformance during subsequent recessions or expansions.

Conclusion

Investors are starting to understand the merits behind a passive investment strategy; that is for certain. In terms of potential downfalls of passive investing, someone can make the theoretical case that “if everyone used index funds, there would be opportunity for active managers.” In fact, they would be right and basic economics would dictate that more investors would move away from indexing and more towards active investing until all of the potential “alpha” disappeared. We are not even close to experiencing that theoretical argument. To argue whether or not indexing leads to inflated prices forgets that active participants are constantly adjusting their positions in order to set “fair prices.” While we anticipate that some investors will flee their passive positions during a market downturn, there is no evidence that suggests that active managers can protect them. A better solution is to partner with a fiduciary wealth advisor who can help you stick with your long term financial plan.

Passive investing is here to stay and the active investment community will need to decide for themselves how they want to reshape their value proposition to their investors.


About the Authors

Tom Allen

Tom Allen

Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.

Mark Hebner

Mark Hebner - Founder, Index Fund Advisors, Inc.  

Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.