The Rise and Potential Risks of Passive Investing

It’s been a long time coming – passive funds’ meteoric surge over the past decade has led to passive funds officially eclipsing actively managed ones in terms of total money managed. According to a Morningstar report published this past August, passive US equity fund assets have overtaken actively managed U.S. equity mutual fund assets for the first time in US history.

Passive investing is a long term investment strategy that includes minimal buying and selling of stocks. The most common form of passive investing typically includes index investing – investments tagged to indexes such as the S&P 500 or the Dow Jones Industrial Average. In more recent years,exchange-traded fund’s (ETF) have also become an incredibly prevalent medium for passive investing. ETF’s are a group of securities, such as stocks or bonds, that are traded similarly to the way a stock is. They’re designed to mirror the overall return investors can expect if they simply bought the entire exchange.

By contrast, active investing is the continuous buying and selling of assets that looks to take advantage of market inefficiencies. Active managers are constantly scouring the markets to find mispriced stocks that they believe will increase in price. Active investing would typically take form in the buying and selling of individual stocks rather than index funds or ETF’s. While passive investors seek to mirror the overall market average return by building a portfolio of stocks that mirrors an entire index or exchange, active investors seek to beat the market average by only investing in individual stocks that they believe will increase in price.

While many tend to associate individual stock picking as the predominant medium for money managers seeking investment opportunities, passive investing has overtaken the market in an incredibly short period of time – the first index was only created in 1976 and in 2007, passive funds made up only 20% of the market. What has caused this investment strategy to become so popular in such a short span of time?

In response to the Great Recession, a growing number of investors have continued to lose faith in money managers to outperform the market. Active managers, that claim to be able to beat the market average using their own market savvy, couldn’t avoid losing money during the recession. As a result, many investors have started to question whether these active managers can truly be relied upon to beat the market. As a result, investors have turned to passive investing as a safer more reliable investment strategy. A recent Morningstar report states that every year since 2006, money has continued to flow out of active equity and into passive equity.

The rise of passive investing can also be attributed to the low cost of overseeing and operating passive investments. Quartz reports that the fees for the most popular passive index funds are approaching zero which in turn, allows passive investment strategies to be more cost-efficient than active ones. It’s possible for fees to be this low due to economies of scale. Fees have been able to become this low in large part due to economies of scale. Large asset management firms who manage trillions of dollars – such as Vanguard or Fidelity – can afford to set incredibly low fees as these fees will still cover their costs. And, because passive investors don’t try to beat the market average by expending labor to find individual investment opportunities, they have fewer labor costs as well. Even when active managers beat the market, their net return is lower than the market average due to the fees they charge for finding individual investments.

While some view passive investing as a more safe and cheap mode of investing, others – such as Michael Burry, who famously made a fortune by betting against the housing market before the Great Recession – are growing increasingly wary of this trend. Burry, who was portrayed in the 2015 film The Big Short – is wary of the increase in popularity of passive investing as he believes there are parallels between passive investing and collateralized debt obligations (CDO’s) the high- risk securities responsible for the financial crisis. In an extensive interview with Bloomberg, Burry claims that index funds distort stock and bond prices similarly to the manner in which CDO’s did for subprime mortgages. One of the major parallels Burry sees between these two trends is the manner in which the prices of these two respective assets are being evaluated. Rather than being set by fundamental security- level analysis, the prices of index funds are being dictated by large quantities of capital flow supported by models.

Another issue Burry sees with passive investing is the liquidity risk associated with the thousands of low value and lower volume stocks that are linked to these indexes. For the financial market’s most popular indexes – such as the S&P 500 and Russell 2000 – stocks that are included within these indexes are being traded at a fraction of the volume that are traded within their respective indices. Burry finds that “the distribution of daily dollar value traded among the securities within the indexes the mimic” is a major issue with virtually all passive fund indexes as he goes on to say, “The theater keeps getting more crowded, but the exit door is the same as it always was. All this gets worse as you get into even less liquid equity and bond markets globally.”

While Burry reminds uncertain of the timeline in which a potential crash could occur, he is becoming increasingly more concerned with the ramifications given the longer this trend continues: “Like most bubbles, the longer it goes on, the worse the crash will be.”

Generally speaking, in terms of passive investing as a concept as well as public outlook, it certainly appears to contain many of the attributes of a bubble: a seemingly risk-free investment strategy with very little discussion occurring regarding potential risk. As investors continue to shrug their shoulders, time will tell if passive investing is as reliable as it seems.