Following on from our last paper on the topical issue of the mega-IPOs and index inclusion, we thought we should revisit the big picture regarding passive investing.
Passive investing is one of the most important investment innovations of the last fifty years. But "important" is not the same as "flawless." Passive investing is a tool, and as with all tools, you need to choose the right tool for the job, and to know how to use it properly. Inexpensive, simple to understand, and having performed particularly well in the last decade, clearly this is a powerful tool.
However, investors should never forget passive’s inherent weaknesses. We highlight a few:
- You still have to choose: “Passive” implies that the investor makes no choices, and this is far from the case. What index are you going to track? The US? Great, but do you choose the Nasdaq, S&P500, or the Russell 2000? Large companies, small or both? Or a global index? MSCI or FTSE? And hold on a second, what if, like most UK investors, almost all of your liabilities are in pounds sterling – why should you be taking such a big currency bet? Should you opt for the local market and miss out on global growth potential? All of these decisions have real and long-lasting implications.
- What about absolute risk? Passives exist to minimise tracking error to an index, nothing else. In other words, passives are focussed exclusively on relative risk. We believe most investors should be most worried about losing and making real money, i.e. absolute risk. It’s easy to paper over this difference in a bull market, but when tough markets set in, most find they cared more about absolute risk and less about relative risk.
- Market timing: One of the biggest risks in investment is how tempting it is to buy the hot theme of the day. And these hot themes are often most attractive after a period of spectacular performance. When the wonderful story inevitably runs into tougher times, investors face rising pressures to throw in the towel. As (almost all) passives have no values other than performance, and since many passive ETFs are intentionally targeting the hot themes of the day, we believe this “buy high, sell low” risk is especially high in passives.
- Pro-momentum: Because many passives are market-cap weighted, they mechanically buy the stocks where share prices have performed the best. This leads to a significant risk that they are overweight the most overpriced, or in other words, makes them inherently pro-momentum. So be it, but remain wary of matching these passive investments with strong growth- or momentum-style holdings – you might be unknowingly doubling up on the same risk.
- Positive feedback: Adding to this, there is a risk of generating a positive feedback loop. What if there is insufficient liquidity to match the index demand? At that point, any buying leads to ever higher prices, which leads to more buying. Brilliant when there are consistent inflows, the cycle turns vicious when there next are sustained redemptions – trees don’t grow to the sky. (Even the ECB is concerned, commenting on the risks here.)
- Stewardship & values: Lastly, one of the great strengths of the capital markets is that they nurture and steward society’s companies. A healthy and efficient corporate ecosystem is essential to the smooth functioning of society – companies touch on all aspects of our lives, after all. Passive investments by their nature take no interest in these values.
None of this amounts to a case against passive investing and the sensible question is not "passive or active?" but "how much passive, which one(s), structured how, and offset by what?" Especially in today’s richly valued and concentrated markets, a portfolio that pairs passive core holdings with value or income tilts, genuine risk awareness and active stewardship is likely to serve an investor — and the broader market ecosystem — far better than an uncritical, all-in allocation to passive alone.
