Passive investing is taking over the world. Okay, that's an exaggeration, but investment researchers at Sanford C. Bernstein & Co. say that nearly half of equity assets in the United States are passively managed, and the trend is growing. These same researchers called passive investing "worse than Marxism."
What exactly is passive investing, and why is it a problem? According to Investopedia, "Passive investing is an investment strategy that aims to maximize returns over the long run by keeping the amount of buying and selling to a minimum." Investors do this by purchasing index funds and exchange-traded funds (ETFs). So what's the problem?
Passive Investing Returns Fall Short
Index funds and ETFs have underperformed Standard & Poor's 500-stock index over the past two years, according to Steven Bregman, co-founder of Horizon Kinetics, an investment adviser firm with a "long-term, contrarian, fundamental value investment philosophy."
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Why? It could be simply the nature of these types of investments. When investors buy into an index fund, they're investing in a predetermined list of stocks. The managers of that index fund have to buy those stocks on the list without considering the valuation of those companies.
As Bregman says, the rise of passive investing "allows the herd to crowd assets and escalate their power without accountability to fundamentals." Does this sound a like a good idea?
A Factor in Bubbles and Flash Crashes
Worse yet, the rise of passive investing may be creating one of the biggest bubbles ever. A bubble can be defined as a situation where money flows in a certain direction without the movement being based on a valuation, which also seems to be one of the defining features of passive investing.
And there's another issue: Computers run index funds and ETFs. The computers buy whenever there's a dip. Those same computers sell when the trend turns the other way, and that can create an irrational panic where even more people sell. Remember the Flash Crash of May 6, 2010? That day the S&P 500 fell 7% in less than 15 minutes. This plunge was partly caused by computers selling off ETFs and index funds. Imagine the bubble—and the crash—if people continue to pour money into passive investing.
The Bottom Line for Investors
Passive investing has its champions. Index funds and ETFs can be low-cost, easy-to-buy, and well, passive—investors don't have to do anything more once they've bought in. But passive investing can also carry danger for individual investors, and maybe more importantly, for the market as a whole.
What Should You Do About It?
Be an active passive investor. Meaning that you should have a stop loss strategy for your equity holdings to protect against large losses when the inevitable bear market comes.
Also, don't forget to rebalance your portfolio quarterly so as to not become overweighted in one sector or index, which can increase your risk.
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