Passive investing has been ridiculed by Wall Street for decades. The following list is just a small sample of the criticisms I’ve collected over the years:
Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins called it worse than Marxism.
David Smith, fund manager at Hargreaves Lansdown, called passive investors parasites on the financial system.
Tim O’Neill, global co-head of Goldman Sachs’ investment management division, warned investors that if passive investing gets too big, the market won't function.
The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Goldman Sachs’ O’Neill has even called passive investing a “potential bubble machine.”
Given the number of questions I get from investors about this issue, one would think that passive investing is now dominating markets. Let’s see if there’s any truth to such beliefs, and whether there’s anything to worry about.
Checking the weather? Guess what—you’re using a model. While models can be useful for gaining insights that can help us make good decisions, they are inherently incomplete simplifications of reality.
In investing, factor models have been a frequent topic of discussion. Often marketed as smart beta strategies, these products are based on underlying models with limitations that many investors may not be aware of.
To help shed light on this concept, let’s start by examining an everyday example of a model: a weather forecast. Using data on current and past weather conditions, a meteorologist makes a number of assumptions and attempts to approximate what the weather will be in the future. This model may help you decide if you should bring an umbrella when you leave the house in the morning. However, as anyone who has been caught without an umbrella in an unexpected rain shower knows, reality often behaves differently than a model predicts it will.
After a period of relative calm in the markets, in recent days the increase in volatility in the stock market has resulted in renewed anxiety for many investors.
From February 1–5, the US market (as measured by the Russell 3000 Index) fell almost 6%, resulting in many investors wondering what the future holds and if they should make changes to their portfolios.1 While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.
If passive investing creates market distortions, active managers can win big.
Challenges to the status quo—political, economic or social—always evoke strong emotions, from enthusiastic support to fierce criticism. The loudest critics often have the most to lose, even if they acknowledge some benefits of the new regime.
This clash is now unfolding over ascendant investment vehicles: index and exchange-traded funds, or ETFs. The dramatic growth of such products has been revolutionary. More investors are choosing indexing over funds managed by traditional stock pickers, known in the industry as active managers. Since 2009, U.S. index funds have seen inflows of some $1.7 trillion, compared with outflows of nearly $1 trillion for actively managed mutual funds.
