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Passive Investing

by Craig Moser on January 26, 2018

When you look at the past 5 years, you see an increase in “passive investing”.  In 2017 alone it has gone up over 500 Billion dollars.  Passive investing is appealing due to lower costs.  There isn’t a person making buy or sell decisions.  You remain in an index of assets regardless of whether they’re good or not.

Looking at the flow of capital into passive portfolios such as the S&P 500, a potential risk can be seen down the road.   A major cash flow into “passive investments” has been from retirement plans.  The continual inflow of capital continues to occur without regard to valuation, earnings, debt ratios etc.

If you, as a company, are an “index component”, you get new investor’s deposits each pay period.   The lack of decision-based investment choices creates risk.  In turn, that reduces the ability of investor’s money to react to distortions or declines on the fundamental side.   In more basic language, there’s less active management to stabilize the markets.

You may consider this a herd mentality.  It could also mean if a negative event occurs, you could see a cascading effect if investors sell their index based investments with the same vigor.   There’s no active manager making value judgments.  No one deciding if there’s a buying opportunity, or a time to exit.  No one making decisions based on traditional investment valuations within an index type investment.

If you look at money flowing to passive funds every month, you can understand why markets have had little to no volatility since the election.   It makes sense if you consider it.  The path of least resistance is into stocks which in turn go higher.  The result is passive investments adding an upward bias to the market.  Passive investing also inflates already-hot market sectors which can create a bubble.

How It Works

Under an indexing strategy, shares of companies with large weightings in major indices attract more capital.  The price of a security ceases to function as a gauge of a firm’s underlying potential or value where passive funds monopolize investment flows.

This can distort the cost of equity and the price of credit.   Under these conditions, serious misallocations of capital can become the norm.  This creates bubbles while leaving innovative investment firms to starve for investor funds.  This isn’t good for productivity or growth.

We need smart people to evaluate companies.  Under the indexing methodology, we see diminished competition when investors simply buy the “market” and disregard valuations and decision making.   Most major stock indexes, including the S&P 500, are “capitalization weighted.”  The greater a stock’s market value, the more influence it has over the index’s moves.  It also means that as cash pours into index funds, the funds heavily invest in stocks with the market’s largest names.

Classic Financial Theory

In classic financial theory, markets set the “correct” price for a stock based on the buy and sell decisions of informed investors.  When money flows into index funds, they must buy stocks in their index regardless of the companies’ financial health or outlook.   Ignoring “price discovery”, the term for researching a stock’s relative value, fewer and fewer investors care about fundamentals.  They simply buy using a low cost index.

If there is another severe bear market in the future, the index investor’s threshold for loss will be tested.  The S&P 500 lost approximately 57% in the 2008-2009 downturn.   We haven’t had anywhere near that type of decline since 2008-2009.  Most have forgotten that loss.

Additionally, with a great deal more currency in our economic system and interest rates held low by central banks, investors have in some ways been pushed into these stock index investments by default.

Minimizing the risk of severe market downturns is one of the most important things asset managers and advisors can do for clients.  In an industry becoming commoditized and compressed due to indexing and lower fees, the risk is that a traditional buy and hold approach coupled with index based investment choices could be a recipe for pain in the future.

 

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